slide1 n.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Money, Prices, and the Federal Reserve PowerPoint Presentation
Download Presentation
Money, Prices, and the Federal Reserve

play fullscreen
1 / 73

Money, Prices, and the Federal Reserve

148 Views Download Presentation
Download Presentation

Money, Prices, and the Federal Reserve

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

  1. Money, Prices, and the Federal Reserve Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University

  2. Introduction • Is Economics about Money? • What is Money? Chapter 23: Money, Prices, and the Federal Reserve

  3. Introduction • Money • Any asset that is generally accepted in making purchases • Examples • Paper Currency, (worthless) Coins, and Checking Accounts • But also • Bronze, Silver, and Gold • Cows, Clams, and Cocoa Beans • At different times and in different places, foreign currency, boulders, even tulip bulbs have been accepted as money. Chapter 23: Money, Prices, and the Federal Reserve

  4. Money and Its Uses • An asset is money if it is … • …A Medium of Exchange • If it is used in purchasing goods and services. • …A Unit of Account • If it is a basic measure of economic value. • …A Store of Value • If is serves as a means of holding wealth. Chapter 23: Money, Prices, and the Federal Reserve

  5. Money and Its Uses • Why is barter inconvenient? • Double coincidence of wants. • Would a bartender accept an economics lecture? • Less specialization • People try to do everything by themselves. • How does money solve this problem? • Why is everyone willing to accept money? • What if people refuse to accept your “money”? Chapter 23: Money, Prices, and the Federal Reserve

  6. Money and Its Uses • Is cash money? • Are checking accounts money? • Are savings accounts money? • Are 3-month certificates of deposit money? • Are 1-year, negotiable, CDs money? • Is a gold mine money? • Is a house money? Chapter 23: Money, Prices, and the Federal Reserve

  7. Commercial Banks and the Creation of Money • How do non-cash assets that are also money (e.g., checking accounts) come into existence? Palazzo Ducale di Venetia Chapter 23: Money, Prices, and the Federal Reserve

  8. Commercial Banks and the Creation of Money • Republic of Venice • Central Bank issues 1 million guilders. Colonna di San Todaro Colonna di San Marco Source of pictures: www.VeNETia.it Basilica di San Marco Chapter 23: Money, Prices, and the Federal Reserve

  9. Commercial Banks and the Creation of Money • People want to place their 1 million guilders in a bank • Why? Why do banks exist? • They are safer than your pocket or couch. • They are convenient (fund transfers, check-writing). • They may pay interest on your deposited funds. • They channel your savings to productive uses. Chapter 23: Money, Prices, and the Federal Reserve

  10. Consolidated Balance Sheet of Venetian Commercial Banks (Initial) Liabilities Deposits 1,000,000 guilders Assets Currency 1,000,000 guilders • Central Bank issues 1 million guilders. • Citizens open accounts and deposit1 million guilders • Deposits are liabilities for the bank • The guilders are an asset for the bank Chapter 23: Money, Prices, and the Federal Reserve

  11. Commercial Banks and the Creation of Money • If a bank receives deposits and keeps them, those guilders are the bank’s reserves. • Bank Reserves • Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments • Suppose Reserves = deposits. Then we have 100% reserve banking. Chapter 23: Money, Prices, and the Federal Reserve

  12. Commercial Banks and the Creation of Money • Why keep Reserves? • Because if depositors want to withdraw some of their funds, the bank must have cash available. • Why not keep 100% Reserves? • Because a bank’s business is to lend out funds (i.e., its depositors’ savings). • How much should banks keep in Reserves? • The Central Bank’s requirement, • plus predicted withdrawals. Chapter 23: Money, Prices, and the Federal Reserve

  13. Commercial Banks and the Creation of Money Chapter 23: Money, Prices, and the Federal Reserve

  14. Commercial Banks and the Creation of Money • Reserves are not part of the money supply (they cannot be used for exchange with goods/services). • Deposits are part of the money supply (you can write checks on your checking deposits). • Remember checks are NOT money! Chapter 23: Money, Prices, and the Federal Reserve

  15. The Process of Deposit Creation

  16. Consolidated Balance Sheet of Venetian Commercial Banks (Initial) Liabilities Deposits 1,000,000 guilders Assets Currency 1,000,000 guilders • Central Bank issues 1 million guilders. • Citizens open accounts and deposit1 million guilders • Deposits are liabilities for the bank • The guilders are an asset for the bank Chapter 23: Money, Prices, and the Federal Reserve

  17. The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After One Round of Loans Liabilities Deposits 1,000,000 guilders Assets Currency (= reserves) 100,000 guilders Loans to farmers 900,000 guilders • Fractional Reserve Banking System • Bankers agree they only need a reserve to deposit ratio of 10% • R = r D = 0.1 D • Required reserves = 100,000 guilders, 10% of deposits • Lend the excess reserves of 900,000 guilders Chapter 23: Money, Prices, and the Federal Reserve

  18. Palazzo Ducale di Venetia $ Bank 1 Source http://www.dtsonline.com/media/img_investors.jpg Chapter 23: Money, Prices, and the Federal Reserve

  19. Palazzo Ducale di Venetia $ Bank 1 $ Bank 2 Chapter 23: Money, Prices, and the Federal Reserve

  20. $ Bank 1 $ Bank 2 $ Bank 3 Chapter 23: Money, Prices, and the Federal Reserve

  21. $ Bank 1 $ Bank 2 $ Bank 3 $ Bank 4 Chapter 23: Money, Prices, and the Federal Reserve

  22. 1000 $ Bank 1 900 $ Bank 2 900 810 $ Bank 3 810 729 $ Bank 4 729 Chapter 23: Money, Prices, and the Federal Reserve

  23. Deposits 1000+ 900 + Notice how the original deposit of 1000 has gotten multiplied. Because Deposits are part of money, the money supply has grown by $3439 810 + 729 3439 Chapter 23: Money, Prices, and the Federal Reserve

  24. The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After One Round of Loans Liabilities Deposits 1,000,000 guilders Assets Currency (= reserves) 100,000 guilders Loans to farmers 900,000 guilders • Fractional Reserve Banking System • Bankers agree they only need a reserve to deposit ratio of 10% • R = r D = 0.1 D • Required reserves = 100,000 guilders, 10% of deposits • Lend the excess reserves of 900,000 guilders Chapter 23: Money, Prices, and the Federal Reserve

  25. The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After One Round of Loans Liabilities Deposits 1,900,000 guilders Assets Currency (= reserves) 1,000,000 guilders Loans to farmers 900,000 guilders • Loan proceeds are redeposited • Reserves = 100,000 + 900,000 = 1,000,000 guilders • Deposits = 1,900,000 guilders • Money supply = Deposits = 1,900,000 guilders • Excess reserves = Reserves – 0.1 * Deposits • Excess reserves= 1,000,000 – 0.1 * 1,900,000 • Excess reserves= 1,000,000 – 190,000 = 810,000 • Banks can lend the excess 810,000 guilders Chapter 23: Money, Prices, and the Federal Reserve

  26. The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After Two Rounds of Loans and Redeposits Liabilities Deposits 1,900,000 guilders Assets Currency (= reserves) 190,000 guilders Loans to farmers 900,000 guilders Loans to merchants 810,000 guilders • Lend excess reserves • Reserves = 190,000 guilders • Deposits = 1,900,000 guilders • Money supply = Deposits = 190,000 guilders • Loans = 900,000 + 810,000 = 1,710,000 Chapter 23: Money, Prices, and the Federal Reserve

  27. The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After Two Rounds of Loans and Redeposits Liabilities Deposits 2,710,000 guilders Assets Currency (= reserves) 1,000,000 guilders Loans to farmers 900,000 guilders Loans to merchants 810,000 guilders • Loan proceeds are redeposited • Reserves = 190,000 + 810,000 = 1,000,000 guilders • Deposits = 1,900,000+ 810,000 =2,710,000 guilders • Money supply = Deposits = 2,710,000 guilders • Excess reserves = Reserves – 0.1 * Deposits • Excess reserves= 1,000,000 – 271,000 = 729,000 • Excess reserves = 729,000 guilders Chapter 23: Money, Prices, and the Federal Reserve

  28. The Process of Deposit Creation Also Reserves = original injection of Reserves by Central Bank = 1 million Notice Reserves = 10% of D … … … DD=10*DR Chapter 23: Money, Prices, and the Federal Reserve

  29. The Process of Deposit Creation Also Reserves = original injection of Reserves by Central Bank = 1000 Notice Reserves = 10% of D … … … DD=10*DR Chapter 23: Money, Prices, and the Federal Reserve

  30. The Process of Deposit Creation Final Consolidated Balance Sheet of Venetian Commercial Banks Liabilities Deposits 10,000,000 guilders Assets Currency (= reserves) 1,000,000 guilders Loans to farmers 9,000,000 guilders • Observations • Lending will continue to keep the 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 Chapter 23: Money, Prices, and the Federal Reserve

  31. Commercial Banks and the Creation of Money • The use of a fractional-reserve banking system allows the money supply to grow as a multiple of the reserves. • In Venice, with a 10% reserve-deposit ratio,1 guilder in reserve can support 10 guilders in deposit. • The CB creates currency, which is kept by banks as reserves. As long as banks have reserves, they can make loans, which are redeposited and become money. Chapter 23: Money, Prices, and the Federal Reserve

  32. Commercial Banks and the Creation of Money • Summary • R = r D • Bank reserves/bank deposits = desired reserve-deposit ratio • R / D = r • Bank deposits = bank reserves/desired reserve-deposit ratio • D = R / r Chapter 23: Money, Prices, and the Federal Reserve

  33. Commercial Banks and the Creation of Money • The Central Bank can control the amount of money in an economy by • Printing more (or fewer) dollar bills. • It gives them out by exchanging them for government bonds or by lending them to banks. • Changing the reserve requirement ( r ). Chapter 23: Money, Prices, and the Federal Reserve

  34. Exercise 23.2 • Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 1m guilders. • How does the money supply change? • Since we are still assuming people don’t hold currency, the 1m guilders must be held as reserves by the banking system. • Without currency, money supply = deposits. • Deposits = (1/r)*Reserves • DDeposits = (1/r)*DReserves • 10m = 10*1m = (1/0.10)*1m Chapter 23: Money, Prices, and the Federal Reserve

  35. Exercise 23.2 • Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 2m guilders. • How does the money supply change? • Without currency, money supply = deposits. • Deposits = (1/r)*Reserves • DDeposits = (1/r)*DReserves • 20m = 10*2m = (1/0.10)*2m Chapter 23: Money, Prices, and the Federal Reserve

  36. Exercise 23.2 • Suppose banks’ desired reserve/deposit ratio is 5%, and the CB prints 1m guilders. • How does the money supply change? • Deposits = (1/r)*Reserves • DDeposits = (1/r)*DReserves • 20m = 20*1m = (1/0.05)*1m Chapter 23: Money, Prices, and the Federal Reserve

  37. Money Supply with Both Currency and Deposits

  38. Commercial Banks and the Creation of Money • Money Supply = Currency + Deposits • Money Supply = Currency + R / r • Currency + Reserves = Central Bank Money • If the Central Bank prints $1000, all of it must be held either in Currency or in Reserves. Chapter 23: Money, Prices, and the Federal Reserve

  39. Commercial Banks and the Creation of Money • The Money Supply with Both Currency and Deposits • Suppose residents choose to hold 500,000 guilders as currency • If the CB issues 1 million guilders, people deposit 500,000 in the banks • Reserve-deposit ratio = 10% • Bank deposits = 500,000/0.10 = 5,000,000 Chapter 23: Money, Prices, and the Federal Reserve

  40. Commercial Banks and the Creation of Money • The Money Supply with Both Currency and Deposits • Money supply = currency + bank deposits 5,500,000 = 500,000 + 5,000,000 • But before we found that currency = 0, 10,000,000 = 0 + 10,000,000 • The money supply is reduced by 4,500,000 guilders when the residents hold 500,000 guilders in currency Chapter 23: Money, Prices, and the Federal Reserve

  41. Commercial Banks and the Creation of Money • The Money Supply at Christmas • Currency = 500 • Bank reserves = 500 • Reserve-deposit ratio = 0.20 • Money supply= 500 + 500/.20= 500 + 2,500= 3,000 Chapter 23: Money, Prices, and the Federal Reserve

  42. Commercial Banks and the Creation of Money • The Money Supply at Christmas • If Xmas shoppers withdraw 100 • Money supply= (500+100) + (500 – 100)/0.20= 600 + 400/0.20= 600 + 2,000= 2,600 Chapter 23: Money, Prices, and the Federal Reserve

  43. Commercial Banks and the Creation of Money • The Money Supply at Christmas • Observation • When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. • In general, when people make withdrawals, the money supply contracts by a multiple of the withdrawal. • Fall in Money Supply= (1/r) x Withdrawal – increase in cash held by public Chapter 23: Money, Prices, and the Federal Reserve

  44. Central Banks

  45. Central Banks • Two Main Responsibilities • Monetary policy • Oversight and regulation of financial markets Chapter 23: Money, Prices, and the Federal Reserve

  46. Central Banks • Their primary mission is to promote low inflation, economic growth, and stable financial markets. • The Bank of England was founded in 1694. • The US Federal Reserve System, 1913. • Many Latin American countries founded central banks in the 1920s. Chapter 23: Money, Prices, and the Federal Reserve

  47. Central Banks • Controlling the Money Supply: Open-Market Operations • The primary function of Central Banks is monetary policy. • CBs control the money supply by changing the supply of bank reserves. Chapter 23: Money, Prices, and the Federal Reserve

  48. Central Banks • Controlling the Money Supply: Open-Market Operations (OMOs) • Open-market operations are the most important method of changing the supply of bank reserves. • The “Market” in OMOs is the Market for Government or Central Bank Bonds. • The CB exchanges bonds for currency. Chapter 23: Money, Prices, and the Federal Reserve

  49. Central Banks • Bond • A legal promise to repay a debt, usually including both the principal amount and regular interest payments. Source: www.rainfall.com/ posters/WWI/catalog11.htm Chapter 23: Money, Prices, and the Federal Reserve

  50. Open Market Operations • Increasing The Money Supply • The Fed purchases US government bonds from the public. • The people deposit the funds they get from their sale of bonds to the Fed. • The increase in deposits increase bank reserves. Chapter 23: Money, Prices, and the Federal Reserve