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1International Finance 2003© Natasha Beliaeva

Activator1. Why do you accept money in

exchange for a good or service?

2. What gives money its value?

Represents purchasing power, acceptable form of currency, other people will accept it, etc…

Government says so, domestically and internationally accepted, represents value of goods and services

Jerry Maguirehttp://www.youtube.com/watch?v=OaiSHcHM0PA&list=PLD34B596F99A0DE3C&index=9&feature=plpp_video

Money and BankingEvolution of Money

Money – most basic of all financial assets, used to buy goods and services– Something that is regularly accepted in exchange for

goods and services

Three Functions of money:1. Medium of exchange2. Unit of Account3. Store of Value

Functions of MoneyMedium of Exchange – acts as a payment for goods and services; buyers give sellers in exchange for productsBarter system – economy that relies on the exchange of product for product– The direct exchange of goods and services for other goods and

services.Double coincidence of wants – situation where two people simultaneously have a product that the other wants

Jail economy videohttp://www.youtube.com/watch?v=uvcMvn9azxc&list=PLD34B596F99A0DE3C&index=10&feature=plpp_video

Unit of AccountUnit of Account– an expression of value; a way for comparing the values of goods and services– Keep track of debts and investments

Fossil – $89.95 Bulova – $399.95 Rolex - $11,995

Store of Value – money holds its value if you decide to store it instead of spend it– Helps people convert purchasing power from present to

future value by gaining interest

Functions of Money

The Kinds of MoneyCommodity money – money that has an alternative use as a commodity, which has intrinsic valueIntrinsic value – item would have value if not used as money– Gold, silver, cigarettes (WW2), tulip bulbs (1600’s Europe), etc

The Kinds of Money

Fiat – order/decree; government issued money– Paper dollars– Money that is intrinsically worthless

Legal tender - is money that a government has required to be accepted in settlement of debts

Liquidity – ease with which an asset can be converted into money as a medium of exchange– Liquid – checking account– Nonliquid - House

Functions of Money

Money in the U.S. EconomyMoney supply/stock – quantity of money (paper and digital) in the economy– October 2010 – 9.61 Trillion in M1– Currency – paper bills and coins in the hands of the public

(800 Billion)– Demand deposits – balances in bank accounts, that can be accessed

by writing a check• Checking accounts, travelers checks

Money in the U.S. EconomyM1 – money that people can gain access to easily and immediately; checkable demand deposits. – Highly liquid – physical currency (minted coins and printed paper,

demand deposits (checking accounts, traveler’s checks)M2 – consists of M1 plus accounts that are not as liquid– Slightly less liquid - Savings accounts, certificates of deposits (CDs),

money market, mutual funds, etc.

Banking

The Federal Reserve (“The Fed”) – the central bank of the U.S.Created in 1913 by Congress, Federal Reserve ActCentral Bank – institution designed to oversee the banking system and regulate the quantity of money in the economy.Monetary policy – “money”, directly affects the nation’s money supply (expansionary or contractionary)– Dollar is officially a “Federal Reserve Note”

The Federal Reserve

Central Bank is in Washington D.C.Run by a 7 member board of governorsAppointed by the president, confirmed by the Senate to 14 year termsBoard is led by the chairmanCurrent chairman – Ben Bernanke

Structure of the Federal Reserve

Fed is comprised of Twelve Federal District Reserve Banks– One Federal Reserve Bank for each district– Each FRB monitors economic and banking conditions in its

district

Structure of the Federal Reserve

The Fed’s Organization

Federal Reserve Bank Atlanta – Atlanta District

The Federal Open Market Committee

Structure and function:Run by the 7 member board of governors (Washington D.C.) and 5 of the 12 regional bank presidentsAll attend, only 5 vote, President of New York Fed always votes (financial capital of the world

The Federal Open Market Committee

Power and Influence:Increase or decrease the $ money $ supplyOpen-market operation – buying and selling U.S. government bonds

Increase money supply – buy government bonds from the public (quantitative easing)Decrease money supply – sell government bonds to the public

Think of a dam…

A dam controls the flow of water downriver.Releasing too much water would cause flooding.Too little water would cause a drought.

The Fed is like a dam...

The Fed is like a dam...The river is the $ supply.Too much $ causes inflation.Too little $ can cause a recession.

Federal Reserve

Money Supply

Three monetary policy tools 1. Open-market operations2. Reserve requirements 3. Interest Rates

(Federal Funds Rate)

The Fed’s Tools of Monetary Control

Money Supply and Lending

Picture This

Open-Market Operations – the purchase and sale of U.S. government bonds by the Fed– Most often used tool of the FedIncrease the Money Supply– Buy bonds from the banks – credit the banks with money, increases the money

supply• Easy money policy - expansionary monetary policy, goal is to expand the

economy by lowering interest rates, increase inflation, encourages banks to lend money to consumers , discourage saving

Open-Market Operations

– Decrease money supply– Sell bonds to the bank, withdrawal money, decrease the money supply

• Tight money policy – contractionary monetary policy, goal is to slow the economy by raising interest rates, contracting the economy, cause inflation to slow, discourage borrowing, encourage saving, restricts the money supply

Open-Market Operations

Open-Market OperationsExpansionary Monetary Policy

Contractionary Monetary Policy

Fed Bond Buying

http://www.youtube.com/watch?v=Syk19wfGJRo

http://www.youtube.com/watch?v=8nmTIjbTy3E

http://www.youtube.com/watch?v=YdD1V2CgauY

http://www.youtube.com/watch?v=A3_ymwSDcQQ

Brainstorm - FED

Fractional-reserve system – banks hold only a fraction of deposit reserves as opposed to 100% of depositsReserve – money deposit that banks have received but not loaned out

Fractional Reserve System

Reserve Requirements – regulations on the minimum amount of reserves that banks must hold against deposits– Banks must have a supply of reserves to protect against "runs" or "panics.“ (

it’s a wonderful life video clip) Modern Bank Runs– 10% on M1 – Influences how much money banks can create from each deposit (reserves)– Increase in RRR, banks must hold more reserves, can loan out less– Decrease in RRR, banks must hold less reserves, can loan out more

Reserve Requirements

Country 1968 1978 1988 1998

United Kingdom 20.5 15.9 5.0 3.1

Turkey 58.3 62.7 30.8 18.0

Germany 19.0 19.3 17.2 11.9

United States 12.3 10.1 8.5 10.3

Required Reserve Ratio – set by the Fed, minimum amount that must be held by the bank– Established by the Federal Reserve, currently 1/10 or 10%

of M1– $1000 deposit, the bank would hold $100 in reserve and

have $900 for lendingRequired Reserves– the portion/percentage of a money deposit that must be held by the bank– May not be loaned out– Protect the bank against withdrawals on demand deposits

Excess Reserves – bank reserves in excess of the reserve requirement set by the Fed – They are reserves of cash more than the required amounts– May be loaned out or used for withdrawals on demand

depositsLoans - portion of deposit that is loaned out to borrowers– Money supply does not increase until banks actually lend

money into circulation

Money Creation

Banking Simulation

Name Deposit Amount Required Reserves

Excess Reserves

Banking Simulation

Name Loan Amount

Total Deposits ___________

Total Reserves ___________

Excess Reserves ___________

Total Loans ___________

Remaining Excess Reserves _______

T Account – simplified accounting statement that shows changes in the banks assets and liabilities– Reserves and loans are assets to bank– Deposits are liabilities to the bank

Money Creation

T-Account for a Typical Bank

ASSETS LIABILITIES

Reserves 10 100 Deposits

Loans 90

Total 100 100 Total

Example

AssetsRequired Reserves: 5,000Excess Reserves: 30,000Loans: $15,000

LiabilitiesDemand Deposits: $50,000

1. What is the reserve requirement?2. Assume that a withdrawal is made in the amount of $3,000 from the demand deposits.

1. How much will the reserves change?2. Does the M1 money supply change?3. As a result of the withdrawal, what is the new value of the excess reserves?

Rules for Free Response

1. 1 pt of extra credit for each correct answer on next test

2. One copy for me (all names of group)3. One copy for you (check your answers)4. No phones during free response

Money multiplier formula – helps determine the amount of money that the banking system generates with each dollar of reservesMM = 1/RRR– 1/.10 = 10– 1/.05 = 20

Money Creation– Initial Cash Deposit (principal) x (MM)– The higher the RRR, the less banks have to loan out (vice versa)– 100(10) = 1000– 100(20) = 2000

Money Multiplier

M o n ey m u ltip lie r =1

R eq u ired rese rv e ra tio

Personal Deposit

Deposit (Money Supply)

Required Reserves (Assets)

Excess Reserves (Liabilities)

Person A

Person B

Person C

Totals

Money Multiplier

$200 $1800$2000

$1800 $180 $1620

$1620 $162 $1458

$5420 $542

• Initial Cash Deposit (1 ÷ RRR)• 2000 X 10 = $20,000

Fractional Reserve System Video

http://www.youtube.com/watch?v=WMTyKduYrUk&list=PL58EB0BBFE9FC05FF&index=31&feature=plpp_video

RRR and Money Multiplier Worksheet

RRR Required Reserves

Excess Reserves

Personal Deposit

Person A $1,000 100 900

Person B

Person C

Person D

Person E

Totals

Money Multiplier

Personal Deposit

Person A $1,000 100 900

Person B 900 90 810

Person C

Person D

Person E

Totals

Money Multiplier

Personal Deposit

Person A $1,000 100 900

Person B 900 90 810

Person C 810 81 729

Person D

Person E

Totals

Money Multiplier

Personal Deposit

Person A $1,000 100 900

Person B 900 90 810

Person C 810 81 729

Person D 729 72.9 656.10

Person E

Totals

Money Multiplier

Personal Deposit

Person A $1,000 100 900

Person B 900 90 810

Person C 810 81 729

Person D 729 72.9 656.10

Person E 656.10 65.61 590.49

Totals

Money Multiplier

Personal Deposit

Person A $1,000 100 900

Person B 900 90 810

Person C 810 81 729

Person D 729 72.9 656.10

Person E 656.10 65.61 590.49

Totals 4095.10 409.51

Money Multiplier

3. From person A to B the money supply rose to $19004. In only 5 rounds of spending the money supply rose from $1000 to 4095.105. What would happen if the bank continued to loan excess reserves? The money could potentially grow to $10,000

RRR and Money Multiplier Worksheet

RRR Initial Deposit

Multiplier Increase in Money Supply

$100,000

$20,000

$10,000

$6,666

$4,000

• 1%• Did not grow as much• Hyperinflation• Lack of growth in the economy

A $2000 deposit is made in the bank and the RRR is 12%.1. How much must be held as required reserves?2. How much will be available in excess reserves?3. How much could the initial deposit increase the money supply if

the RRR was 12%?4. How much could the initial deposit increase the money supply if

the RRR was 10%?5. How much could the initial deposit increase the money supply if

the RRR was 5%?6. Which RRR yielded the greatest amount? Explain why.

RRR and Money Multiplier Review

2000 x .12 = $240

2000 – 240 = $1760

MM = 1/.12 = 8.3

2000 x 10 = $20,000

2000 x 20 = $40,000

5%. The lower the RRR, the higher the excess reserves available to loan out, which subsequently add a greater amount to the money supply.

2000 x 8.3 = $16,666.67

MM = 1/.10 = 10

MM = 1/.05 = 20

Discount Rate – interest rate on loans the Fed makes to banks; currently .75%– Fed is the lender of last resort– Banks borrow from Fed when it has low

reserves; too many loans, high withdrawals– Lower discount rate encourages borrowing– Higher discount rate discourages borrowing

Federal Funds Rate – short-term interest rate that banks charge each other for loans– Currently 0 - .25%

Interest Rates

Discount Rate

Federal Funds Rate

(Federal Funds Rate)

The FederalReserve “The FED”

Board of Governors (7)Washington D.C

12 District Banks

Federal Open Market Committee (FOMC)

Monetary Policy

2. Required Reserve Ratio (RRR)

3. Interest RatesDiscount Rate/Federal Funds Rate1. Open Market Operations

Sell Bonds = Decrease MSBuy Bonds – Increase MS

Increase RRR – Decrease MSDecrease RRR – Increase MS

Decrease IR - Increase MS Decrease IR – Decrease MS

Buying and selling of government bonds

Percentage of demand deposits that must be held in reserves (10%)

DR – I.R. charged by the FedFFR - I.R. charged on overnight

lending from bank to bank

Tight Monetary Policy (Tight, Contractionary) Loose Monetary Policy (Easy, Expansionary)

Tight vs. Loose Monetary Policy

The Fed sells bonds (securities) to the banks, taking money out of the economy.

This pushes up the federal funds rate (interest rate charged from bank to bank).

Banks then have to charge higher interest rates to households and firms causing the price of a bond to fall.

Consumers and businesses are given less incentive to borrow and more incentive to save.

Decreased borrowing leads to decreased spending.

Decreased spending leads to a contractionary economy and slows down the economy.

The Fed buys bonds (securities) from the banks, adding money into the economy.

This brings down the federal funds rate (interest rate charged from bank to bank).

Banks then can charge lower interest rates to households and firms causing the price of a bond to fall.

Consumers and businesses are given the incentive to borrow.

Increased borrowing leads to increased spending.

Spending leads to economic growth and increased employment.

Free Response Question

What was the intent of this question?Part (a) asked students to use the balance sheet of a bank to find the reserve requirement. Part (b) tested their ability to identify the effect of a cash withdrawal on bank reserves, explain the effect of the cash withdrawal on the money supply, and identify the effect of the cash withdrawal on excess reserves. Part (c)asked students to identify how a bank with deficient reserves could meet its reserve requirements.What were common student errors or omissions?Students had difficulty explaining the effect of a cash withdrawal from a bank on the M1 measure of the money supply and calculating the level of excess reserves after the cash withdrawal.

1. a. Open market operations b.

3. $18,0004. 1/.20 = 55. $10000 x 5 = $50,0006. Less, because a smaller amount of each loan gets re-deposited

to be available to be loaned again.7. Less, because a smaller amount of each deposit gets loaned out

to be available to be deposited again.

Chapter 29 – Practice Worksheet

8. a. 1,000, because there is 1,000 of currency and 0 of deposits.b. 1,000, because there is now 0 of currency and 1,000 of deposits.c. 1,000 x (1/0.20) = 5,000, because 1,000 of new reserves can

support 5,000 worth of deposits.d. The total potential increase is 5,000, but 1,000 was currency

already in the system. Thus, an additional 4,000 was created by the banks.

e. 1,000 x (1/0.10) = 10,000.f. Banks can create more money from the same amount of new

reserves when reserve requirements are lower because they can lend a larger portion of each new deposit.

g. 1,000 x 1/(0.10+0.10) = 5,000.h. Yes, they are the same. With regard to deposit creation, it

doesn’t matter why banks hold reserves. It only matters how much they hold.

Chapter 29 – Practice Worksheet

Chapter 29 Homework, pgs. 644-6451. Why is a dollar bill worth anything?2. What proclamation holds this to be true?3. What type of currency are dollar bills?4. What is the more profound reason that a dollar bill has value?5. Why is the dollar a result of "network effects"?6. What other forms of currency have been used as a medium of

exchange?7. What gave them acceptability as currency?8. How did Saddam Hussein deal with the economic sanctions after

the gulf war of 1991?9. What happened to "Saddam dinars"?10. How did the social conventions of the Kurdish people affect their

use of Swiss dinars?11. What happened to the value of the Swiss dinar as the likelihood

of a U.S. invasion approached?12. Why was the eventual exchange rate for the Swiss dinar higher

than the official rate of exchange?13. What does this story show about paper currency?14. What is the one of the most important elements of paper money?

The FederalReserve “The FED”

Board of Governors (7)Washington D.C (Public)

12 District Banks(Private)

Federal Open Market Committee (FOMC)

Money Supply

2. Required Reserve Ratio (RRR)

3. Discount Rate/Federal Funds Rate

1. Open Market Operations

Sell Bonds – DecreaseBuy Bonds - Increase

Increase RRR – DecreaseDecrease RRR - Increase

Increase – DecreaseDecrease - Increase

Buying and selling of government bonds

Percentage of demand deposits that must be held

in reserves (.10)

Interest rate charged to member banks by the Fed/I.R. charged on overnight lending from bank

to bank

Money Multiplier

Binder Check – Due Monday 4-18-2011

1. Free Responses2. Notes Ch. 29 3. Daily Tens4. Terms5. Fed Webquest

1. Name2. Date3. Class Period4. ID: A, B, C5. Chapter 29 Test

Extra CreditPolitical Cartoons:

What do you think the event(s) or issue(s) are that inspired the cartoons? What are the cartoonists trying to portray in the cartoons? Are there any real people/places/symbols in the cartoon? Who are these people? What do they represent

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