How Do People Make Money?. Discussion: What are some ways that you have earned or made money?
In this chapter, look for the answers to these questions: What assets are considered “money”?...
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In this chapter, In this chapter, look for the answers to these look for the answers to these questions: questions: What assets are considered “money”? What are the functions of money? The types of money? What is the Federal Reserve? What role do banks play in the monetary system? How do banks “create money”? How does the Federal Reserve control the money supply? 1
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Transcript of In this chapter, look for the answers to these questions: What assets are considered “money”?...
In this chapter, In this chapter, look for the answers to these look for the answers to these questions:questions: What assets are considered “money”? What are
the functions of money? The types of money?
What is the Federal Reserve?
What role do banks play in the monetary system? How do banks “create money”?
How does the Federal Reserve control the money supply?
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What Money Is and Why It’s Important
Without money, goods and services have to be exchanged
Every transaction would require a
Most people would have to spend time
With money people and hence society saves on
Hence money fosters
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The 3 Functions of Money Medium of exchange:
Unit of account:
Store of value:
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The 2 Kinds of Money
Commodity money:
Fiat money:
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Measures of the U.S. Money Supply M1:
M2:
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Central Banks & Monetary Policy
Central bank:
Monetary policy:
Federal Reserve (Fed):
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The Structure of the FedThe Federal Reserve System consists of:
Board of Governors (7 members), located in Washington, DC
12 regional Fed banks, located around the U.S.
Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy.
Ben S. BernankeChair of FOMC,
Feb 2006 – present
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Bank Reserves In a fractional reserve banking system,
The Fed establishes
Banks may hold more than
The reserve ratio,
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Bank T-account T-account:
Example:
FIRST NATIONAL BANK
Assets Liabilities
Banks’ liabilities include
In this example,
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Banks and the Money Supply: An Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply, we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans
3. Fractional reserve banking system
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Banks and the Money Supply: An Example
CASE 1: No banking system
THE MONETARY SYSTEM 12
Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FIRST NATIONAL BANK
Assets Liabilities
FNB holds
Money supply =
In a 100% reserve banking system,
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Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Money supply =
FIRST NATIONAL BANK
Assets Liabilities
Suppose R = 10%.
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Banks and the Money Supply: An Example
How did the money supply suddenly grow?
CASE 3: Fractional reserve banking system
A fractional reserve banking system
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Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
If R = 10% for SNB, it will
SECOND NATIONAL BANK
Assets Liabilities
Suppose borrower deposits the $90 at Second National Bank (SNB).
Initially, SNB’s
T-account looks like this:
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Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
If R = 10% for TNB, it will
THIRD NATIONAL BANK
Assets Liabilities
The borrower deposits
Initially, TNB’s
T-account looks like this:
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Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The process
Original deposit =
FNB lending =
SNB lending =
TNB lending = ...
$ 100.00
...
Total money supply =
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The Money Multiplier Money multiplier:
The money multiplier equals
In our example,
Exercise - 1Exercise - 1
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While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account.
The Fed’s reserve requirement is 20% of deposits.
A. What is the maximum amount that the money supply could increase?
B. What is the minimum amount that the money supply could increase?
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The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs):
To increase money supply
To reduce money supply,
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The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR):
To increase money supply,
To reduce money supply,
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The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
When banks are running low on reserves,
To increase money supply,
To reduce money supply,
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The Federal Funds RateOn any given day, banks with insufficient reserves
The interest rate on
The FOMC uses OMOs to
Many interest rates are
The Fed Funds Rate and Other Rates, 1970-2008
(%)
0
5
10
15
20
1970 1975 1980 1985 1990 1995 2000 2005
Fed funds
prime
3-month Tbill
mortgage
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Monetary Policy and the Fed Funds Rate
rf
FD1
3.75%
F2 F1
3.50%
The Federal Funds marketFederal
funds rate
Quantity of federal funds
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Problems Controlling the Money Supply
If households hold more of their money as currency
If banks hold more reserves than required,
Yet, Fed can compensate
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Bank Runs and the Money Supply A run on banks:
Under fractional-reserve banking,
Also, banks may make
These events
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Bank Runs and the Money Supply
During 1929-1933, a wave of bank runs and bank closings caused money supply to fall 28%.
Many economists believe this contributed to the severity of the Great Depression.
Since then, federal deposit insurance has helped prevent bank runs in the U.S.
In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and was eventually taken over by the British government.
