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Money, Prices, and the Federal Reserve

Money, Prices, and the Federal Reserve. Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University. Introduction. Is Economics about Money? What is Money?. Introduction. Money Any asset that is generally accepted in making purchases Examples

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Money, Prices, and the Federal Reserve

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  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

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