Money and Banking, the Fed,

1. Money and Banking, the Fed, Money Creation, & Monetary Policy Monetary Policy 1. Discount Rate 2. Reserve Ratio 3. Bonds Ben Bernanke

2. There is$800billionin currency [notes& coins]. [2/3 is overseas] Money and Banking Money= paper notes + coins + Demand Deposits [52%] [2%] [46%] “Anything you can buy a candy bar with”

3. . 1. Three functions (roles) of money a. medium of exchange b. unit of account c. store of value 2. What constitutes money in our economy? (paper dollars-52%) (coins-2%) b. DD-46% 3. What “backs” the money supply? (gold/silver/the faith of the “G”) 4. Explanation of the demand for money. Dt + Da = DM 5. The four-part make-up of the Federal Reserve a. Board of Governors b. FOMC c. 12 Fed Banks d. Member banks Money– any good widely accepted for goods and services or repayment of debt. Money is anything generally acceptable as a medium of exchange. Objectives For Money and Banking a.Currency “Faith” of the “G”

4. 7th-G-Chicago (1) 8th-H-St. Louis (3) 9th-I-Minneapolis (1) 10th-J-Kansas City (3) 11th-K-Dallas (3) 12th-L-San Francisco (4) 1st-A-Boston(0) 2nd-B-New York (1) 3rd-C-Philadelphia(0) 4th-D-Cleveland (2) 5th-E-Richmond (2) 6th-F-Atlanta (5) Paper notes printedat: 1. FW Currency Center 2. Washington D.C. Coins minted at: 1. Denver 2. Philadelphia 3. San Francisco

5. Dollar Decoded Bills are crowded with numbers and letters that help the U.S. Treasury track printing errors & authenticate currency. Here’s what many of them mean: Fed bank that issued the bill [Chicago] Last letter tells how many times serial number has run Number corresponds to letter in circle indicating issuing Fed bank. First letter corresponds to issuing Fed bank

6. New $20 colors arepeach, blue, andgreen. [Jackson’s portrait is larger, free from the oval] New background colors add an extra layer of complexity for counterfeiters Ink appears either copper or green, depending upon the angle at which the bill is viewed. This is the20’s 20thnew look. The $20 bill is the most counterfeited in the U. S., while the $100 is most counterfeited abroad. The average $20 bill lasts 3 years. The first $20 bill was introduced in 1861. Back then, $20 was about the monthly wage for manual laborers. There are 5 billion twenties in circulation, enough to circle the earth 19 times. An ATM can hold up to 7,500 bills, or $150,000 in twenties.

7. $100Dollar Bill – Red Polymer Thread $50 – Yellow $20 – Green $10 – Orange Now the “5” screams, “I am a 5.” $5 - Blue [They were not going to change the $5 note but –counterfeiters were bleaching Abe & printing Ben on them as they had similar security features. It has2 new water marks and purple ink. [no oval]

8. No paper notes larger than $100 have been printedsince 1946. There will be another new $100 bill in late 2008. It will combine micro-printing with tiny lenses – 650,000 for a single bill. The lenses magnify the micro-printing in a remarkable way. Move the bill side to side, and the image appears to move up & down. Move the bill up and down, and the image appears to move from side to side. It is a very complex optical structure on a microscopic scale. The government prints 38 million notes each business day with a face value of$750 million. [70% of the $800 million currency is $100 bills.]

11. And – what about the new “Bush Dollar” coming out next week? And the new $1 bill coming out Wednesday?

12. Bush $200 Counterfeit Bill This phony Bush $200 bill showed up at a Kentucky Dairy Queen. The serial #: DUBYA402001 Ronald Reagan signed it as Sec. of Treasury A man bought a $2 sundae & got 198.00 in real cash On some of the signs were these: “We like broccoli.” “We like ice cream.” “U.S.A. deserves a tax cut.”

13. History of U.S. Money Beaver skins [1600’s-1800]were traded to the Indians for wampum [clamshells]. Tobacco Leaves became legal tender in 1642. Cut nails were used as change. 100 nails were worth 10 pence. Pine Tree Shilling [1642-1684]became the first minted American coin. Spanish milled dollar was the main coin of the 1770’s. [“Piece of Eight”] An average colonial worker earned two bits a week. Many of you already understand the history of money. Your parents give you money and – it becomes “history”.

14. Wildcat Banking 1790-1860 Over 3,000 banks issued 10,000 bills but 5,000 were counterfeit. Because some banks were more sound than others, a $5 note at one rarely had the same purchasing power as a $5 note at another. State banks issued paper notes in denominations from $1 to $13. They lost their value the farther away you were, thus the name, “wildcat banking”, only a wildcat could get back to a distant bank to verify its authenticity.

15. “Greenbacks” This $450 million brought on severe inflation. Civil War Money1860-1865 Both the Union & the Confederacy paid troops with notes. In 1861, the nation issuedGreenbacks[1st paper money issued by the federal G]. These $5’s, $10’s, & $20’s[total of $10 M] were redeemable in coins. In 1862, $450 M in U.S. notes, from $1-$10,000replaced the Greenbacks. Because of widespread hoarding of coins, Congress issued 5, 10, 25, & 50 cent notes. They were called “paper coins”or “shinplasters.”Northern prices doubledfrom 1861-1864. The South issued Confederate notes. Note-holders were to be repaid in gold & silver after the Civil War. Northerners printed up counterfeit confederate notesso these notes increased 20-fold from 1861-1865 and inflation increased9,200%.$2 billionfrom .50 to $1,000printed.

16. Under thegold standard, $35 of currencycould be redeemed for one ounce of gold. You could bring $35 of billsto the U.S. Treasury and exchange it for an ounce of gold. Gold Certificates (1865-1933)&Silver Certificates (1878-1964) To increase its reserves of precious metals, the U.S. issued these. The largest was a $100,000 gold certificate which was not available to the public but was used only among Fed banks. Silver certificates had denominations from $1 to $1,000. Federal Reserve Notes(1914-Fed was established in 1913) Modern coins are produced by mints in Phil., S.F., & Denver. Federal Reserve Notes make up more than 99.9% of today’s paper currency. Notes of denominations from $5 to $10,000 circulated until 1946. Since 1946, all notes greater than the $100 were retired. The $1 note was not introduced until 1963 [previously the $1 silver certificate served as the $1 bill]. In 1929, all notes were reduced by about 1 inch in length and about ½ inch in width. $500 million of paper money is shredded each day.

17. Yap Island Money “Rai” Yap Island is a tiny, U.S. trust territory in the S. Pacific, 500 miles from Guam. It is one of the 4 Federated States of Micronesia & has12,000 Yapese & 6,000 “rai” limestone stones.

18. The Advantages of a Monetary System Over a Barter System

19. Barter – goods and services were traded without the exchange of money. However, before trade could occur, there had to be a “double coincidence of wants”. Each trader had to have something the other wanted. I would love to sell you these shoes but I can’t eat chicken, due to my bad teeth, caused by smoking. I’ll trade you a chicken for a pair of shoes. In a barter economy a chicken farmer who wants to buy shoes may have to first trade chickens for apples and then apples for shoesbecause the guy selling shoes wants only apples. Money eliminates this problem.

20. You are lucky you are a pineapple farmer and not a broccoli farmer. I hate broccoli. Or, a heart surgeon might accept only certain goods (like pineapples)but not others ( like broccoli) because he doesn’t like broccoli.

21. . It isless expensiveto use money. Using moneysaves timeandtime ismoney. It isless expensiveto use money. The“calculation of exchange”isfast and easy because whatever the price is, you pay that amount. Here’s $3.00 for one gallon. $3.00 The“calculation of exchange”bybartering is much slower than the“calculation of exchange” in amonetary system.

22. The monetary system enables the“calculationof exchange” to go much faster. • Money is also easier to tax. • So a monetary system is betterthan abarter system.

23. Three FUNCTIONS OF MONEY 1.Medium of Exchange [any asset that sellers will accept as payment for g/s] Medium means “something in the middle”, so money is a“medium of trade between buyers and sellers” because it can be exchanged for something else. Avoids “double coincidence of wants” that bartering requires. You would have to have a trading partner who “wants to sell you goods you want to buy”and“wants to buy goods you want to sell.” Liquidity– how easily an asset can be converted intocash without any additional expense.[Cash has 100% liquidity]

24. Three FUNCTIONS OF MONEY $249.00 2.Unit of Account [measuring the relative value of goods by stating prices] Example: Microsoft Stock is selling for $50 a share. The new Jag is selling for $32,000. A $2 item is twice as valuable as a$1 item. Money is like a yardstick. People use it to compare the worth of things that they buy and sell.

25. Three FUNCTIONS OF MONEY Greek Coin 2,500 years old 3. Store of Value[storing wealth from one point in time to another] [doesn’t wear out easily and holds up to inflation] Ability of money to hold value over time [Money that lacked durability or did not hold up well toinflation would not make good money [would not store value]. Ice cream cones would suffer monetary meltdown, become a sticky puddle. If money suffers high inflation, it causes the value of money to “melt.” Other desirable qualities for money are: A. Scarcity B. Portability C. Divisible D. Difficult to counterfeit

26. Two Types of Money • Commodity Money:something that performs the function of money and has alternative, non-monetary uses. Gold, silver, cigarettes, corn • Fiat Money: something that serves as money but has no other important uses. • Paper notes • Coins Alternative uses such as …

27. Money In The American Economy Currency + DD equal M1[Spendable Money] M1 M2 M3 Also included here would beTravelers checks, Checklike deposits[NOWand Super NOWAccts] M1 Completely Liquid $1,375 [billions] 2%52% 46% M1 + savings deposits, small TDs [like CDs & bonds] under $100,000,& MMFs for individuals=M2 M2+ large institutional savings=M3 “V” – how many times a dollar changes hands in a year $6,758 $6,934 [Billions] V = GDP[Y]/M1 = 13 tr./1.3 tr. = 10

28. What about Credit Cards? Are they money? They are not “plastic money.” They do serve as a: 1. medium of exchange& the 2. credit card statementservesas aunit of account. 3. but, they donot have a store of value. If the credit card company goes out of business or decides not to honor your card, it is worthless. They are not money because they don’t store value.

29. What about Debit Cards? Are they money? Debit cards aremoney. They serve as a: 1. medium of exchange; they also serve as a 2. store of value(not an extension of credit); and 3. debit card statementsserve as a unit of account. Debit Card

30. The Value of Money and Price Level Value of Money Prices The value of money goesin the opposite direction of the general price level. Or, the amount a dollar will buyvaries inversely with the price level.

31. 1. The most important function of moneyis as a: (unit of account/store of value/medium of exchange). 2. If you are estimating that it will take $5,000to escort Suzie Rah Rahto the prom so that you can demonstrate your talent with the“Econ Rap,”you are using money as a: (unit of account/store of value/medium of exchange). 3. If you place some of your Kroger’s earnings in a safety deposit box so that you can get your boyfriend, Roger Rocket, a pair of roller blades for Christmas, you are using money as a: (unit of account/store of value/medium of exchange). 4. Estimating expenses for FSU at $16,001illustrates money serving as a (unit of account/store of value/medium of exchange). 5. If Suzie Nomics writes a check for a new Honda, she is using money as a (unit of account/store of value/medium of exchange). 6. M1[also called transactions money or medium of exchange money or “spendable money”] is comprised of coins, paper money and(gold certificates/checkable deposits). 7. The major component of M1is (currency/checkable deposits). 8. The volume of M1is closer to ($1/$3/$4) trillion. 9. (M1/M2)includes non-checkable savings accounts, MMA’s & TDs under $100,000. 10. (Fiat/Commodity) money is money because the G says that it is [G fiat]. 11. The value of money varies(directly/inversely) with the price level. 12. If the price index increases from 100 to 120, the value of the dollar will fall by (one third/one fifth/one fourth). 13. The money supply is backedby (silver/gold/the government). Money NS 1-13

32. 3 Tools of Monetary Policy 1. Discount Rate – banks borrow from the Fed (symbolic) 2. Required Reserve - % of DD which cannot be loaned. 3. Buy/SellBonds – government debt - 3 mo., 6 mo., & 1 year; purchase price:$10,000 - 2 yr., 3 yr., 5 yr.,($5,000), & 10 yr., ($10,000) - 30 years with purchase of $1,000 Federal Funds Target Rate – overnight lending rate between banks to correct a temporary imbalance in reserves. Inflation Raise Raise Sell Recession Lower Lower Buy AS AS AD LRAS AD AD AD PrimeRate-loan rate to the best (prime)customers. Y*YI YR Y* Real GDP 2.3% 17 increases 4%

33. “Easy Money” During Recessions “Students, should the Fed buy or sell bonds to jumpstart this economy?” MS1 MS2 DI Investment Demand 10 8 6 0 10 8 6 0 Nominal Interest Rate Buy DM If there is RECESSION MS will be increased. Money Market QID1 QID2 AD1 [C+Ig+G+Xn] AD2 LRAS “Easy Money” – (Buy/Sell) bonds, which(increase/decrease) MS, which (increase/decrease) interest rates, which (appreciate/depreciate) the dollar, which(increase/decrease) C, Ig, & Xn, which (increase/decrease) AD & therefore, PL, GDP, & emp. AS Jobs are tough to get. Price level P2 E2 P1 E1 YRReal GDP Y*

34. “Tight Money” To Fight Inflation “Now, should I buy or sell?” DI MS1 MS2 Dm 10 8 6 0 10 8 6 0 Investment Demand Nominal Interest Rate Sell If there is INFLATION, MS will be decreased. QID1 Money Market QID2 AS LRAS “Tight Money” – (Buy/Sell) bonds, which(incr/decr) the MS, which (incr/decr) in. rates, which (apprec/deprec) the dollar, which (incr/decr) C, Ig, & Xn, which (incr/decr) AD, PL,& GDP. AD2 “I’ll get rid of some money.” P1 E1 P2 E2 AD1 YI Y*

35. 10 7.5 5 2.5 0 10 7.5 5 2.5 0 Rate of interest, i (percent) Nominal Interest Rate Dt Da 0 50 100 150 200 250 300 0 50100150 200 250 Amount of money demanded (billions) Amount of money demanded (billions) THE Total DEMAND FOR MONEY + = Total demand for money, Dm Transactions Demand, Dt Asset Demand, Da Da [M2] – store of value money Money that we don’t need for daily, weekly, or monthly transactions. We will invest more of it the higher the interest rate. We will hold less because the opportunity cost increases. “Walking around” money M1 Dt Independent of the interest rate Da 10% 8% 6% 4% 2% 0 “I’m losing more interest, the higher the I.R.” Interest Rate Opportunity Cost Da [hold less] Interest Rate Opportunity Cost Da [hold more] CDs or 5% Da varies inversely with the interest rate. 1% 0 50 100 150 200

36. 10 7.5 5 2.5 0 10 7.5 5 2.5 0 10 7.5 5 2.5 0 Rate of interest, i (percent) Nominal Interest Rate Rate of interest, i (percent) Dm Dt Da 50 100 150 200 250 300 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) THE DEMAND FOR MONEY + = Transactions Demand, Dt Asset Demand, Da Total demand for money, Dm [independent][inverse] M 10% 7.5% 5% 2.5% 0 50 100 150 200 250 300

37. 10 7.5 5 2.5 10 7.5 5 2.5 Rate of interest, i (percent) Nominal Interest Rate Dt Da 0 50 100 150 200 250 300 Amount of money demanded [billions] Amount of money demanded [billions] The Demand for Money + = Transactions Demand, Dt Asset Demand,Da Total demand for money, Dm MS2 MS1 MS 10 7.5 5 2.5 0 E Rate of interest, i (percent) 5 Dm 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Money market 1. At equilibrium 5% I.R., the amount of money demanded for transactions is (0/50/100) and the amount demanded as an asset is (0/50/100). 2. If the interest rate were 10%, the amount of money demanded for Dt would be (0/50/100) & the amount demanded as an asset would be (0/50/100). 3. Da slopes down because lower in. rates (incr/decr)the cost of holding money.

38. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market The Dm curve represents the quantity of money people are willing to hold at various interest rates. 7.5 5 2.5 0 MS Dm E Nominal Interest Rate 50 100 150 200 250 300 Money Market Due to a recession, suppose the money supply is increasedfrom $200 billion to $250 billion.

39. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market A temporary surplus of $50 billionbeyond which the people wish to hold, so money becomes a “hot potato”. MS2 MS1 S1 S2 10 7.5 5 2.5 Dm P2 Price of Bonds P1 They react by buying bonds [pushing bond prices up] to meet the desired level of liquidity. Nominal Interest Rate E # of Bonds E 0 50 100 150 200250 300 Money Market

40. Liquidity Trap MS1 MS2 1% LRAS SRAS Dm AD AD Nominal Interest Rate PL YD GDP E 0 500 Money Market Liquidity Trap – in a stagnant economy with interest rates near or at zero, an increase in MS fails to stimulate AD, so recession or depression gets worse. With low returns expected on financial investments, people hoard their money. Banks are unwilling to lend in a slack economy.Fiscal policy is needed here.

41. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market Due to inflation, suppose the money supply is decreased from $200 billionto $150 billion. 7.5 5 2.5 MS Dm E Nominal Interest Rate 0 50 100 150 200 250 300 Money Market

42. The Money Market A temporary shortage of money will require the sale of some assets [bonds-which will make their price fall] to meet the money shortage need. MS2 MS1 Dm S2 S1 10 7.5 5 P1 Nominal Interest Rate Price of Bonds P2 E # of T-bills 0 50 100 150 200 250 300 Money Market

43. Macro Free Response 2007 1. [3 pts] Assume that declining stock market prices in the U.S. cause many U.S. financial investors to sell their stocks and increase their money holdings. (a) Draw a correctly labeled graph of the money market and show the impact of the financial investors’ actions on each of the following. (i) Demand for money (ii) Nominal interest rate MS DM2 DM1 • Answers for 1. (a) (i) [2 points] • (a) (i) In an effort to preserve wealth, • investors sell off stocks when market • prices begin to decline. These new • money holdings will increase the • asset [speculative] demand for money. • In the volatile market, investors will • hold more money while determining • future needs. [2 pts: 1 pt for correct • graph and 1 pt for Dm shifting right.] r2 Nominal Interest Rate r1 Quantity of Money M Tutorial: These will shift the real Dm curve. 1. Changes in real aggregate spending, 2. Advances in banking technology. [ATMs available 24/7 decrease the need for cash (Dm)] 3. Changes in institutions [ability to get interest on checking accounts lead to an increase in Dm], 4. Riskiness of alternative stores of value [stocks]. Dm increases when stocks are appealing. • Answers for 1. (a) (ii) [1 point for saying the interest rate increases] • (a) (ii) The nominal interest rate would increase because the demand • for money increases as the DM curve shifts up, as shown above.

44. Federal Reserve - 1913 A. Boston B. New York C. Philly D. Cleveland E. Richland F. Atlanta G. Chicago H. St. Louis I. Minneapolis J. Kansas City K. Dallas L. San Francisco

45. 12 Fed Banks and 25 Branches 7th-G-Chicago (1) 8th-H-St. Louis (3) 9th-I-Minneapolis (1) 10th-J-Kansas City (3) 11th-K-Dallas (3) 12th-L-San Francisco (4) 1st-A-Boston (0) 2nd-B-New York (1) 3rd-C-Philadelphia (0) 4th-D-Cleveland (2) 5th-E-Richmond (2) 6th-F-Atlanta (5)

46. The Fed’s 25 Branches Fed Quasi-Public Banks.[in combo] Blend of [private ownership(corporations)but public (government)control] The 12 banks are instruments of the government but not owned by the government. The over5,000 banksin the 12 districts buy stock ($1per share)in their district bank (& get 6% dividends[no capital gains]) so the banks are privately owned. Serving the public, it isowned by citizens. The 12 banks are a corporation owned by the banks in their districts, but a public (G) agencydirectly responsible to Congress. They might make $30 billion - 90% to Treasury.

47. Four Part Structure of the Fed Seven Board of Governors • most important body of the Fed • appointed by the Presidentand confirmed by the Senate • 14-year terms are staggered (one replaced each two years) [they arepaid $162,100] • isolationfrom political pressure (only one 14 year term) • the Chairmanserves onlyfour years but can be reappointed [4-year renewable term] 4 times • His pay is $180,100. • Every presidentgets to appoint at least two. Clintonappointed 8 & Bush appointed 4in 1st 2 years. • One term begins every 2 years on Feb. 1 of even numbered years.

48. 2. Federal Open Market Committee [FOMC] -Fed’s main policy-making arm -includes 7 Board of Governors, NY Fed President,and4 other bank presidents(rotate among the other 11 every 3 years) -other 7 bank presidents are non-voting members -they meet every six weeks -they make about $30 bil. a year (90% goes to the Treasury)

49. TheFOMC Meeting RoominWashingtonDC The FOMC meets around a27-foot oval mahogany tablein a room with a23-foot ceilingwith a1,000-pound chandelier. Home of 7 Board of Governors

50. . A Day In The Life Of The FOMC • Typical Meeting • The entire committee [12 members + other 8 bank presidents] examine regional, national and international economic info to assess the strengths and weaknesses of the economy. • After discussing the economy, the voting members vote on the direction of monetary policy. A policy directive describes the committee’sassessment of the economy and the new target fed funds rate. • An announcement is made about 1:15 p.m.