GOVernment in the economy

Part IIa: Money, the Financial System, and the Money Supply

Show Me the Money!

• In economic terms, “money” refers to a generally accepted

medium of exchange.

• It serves three purposes:

• Medium of Exchange. It overcomes the need for a

“double coincidence of wants” to make trade (barter)

possible.

• Store of Value. It is preserves its value until used in

exchange.

• Unit of Account. It is a numeraire: a standardized unit in

which prices can be quoted.

Conceptualizing “Money”.

Types of Monetary Systems

• Commodity Money

• A monetary system in which money is actually a

commodity with intrinsic value, such as precious metals

(e.g. gold or silver).

• Fiat Money

• A monetary system where money has no intrinisic value

but is considered legal tender by government decree.

Based on the “kind” of money being used...

Monetary Aggregates

M1:

Publicly Held Currency + Sight Deposits

M2:

M1 + Savings and Money Market Accounts

M3:

M2 + Larger Fixed-Term Deposits + Nonbank Accounts

Measuring the money supply.

The Federal Reserve System

• The Federal Reserve is the central bank of the United

States.

• Functions:

• Banking regulation.

• Clearing interbank transactions.

• Lender of last resort.

• Conduct monetary policy.

The functions of the Federal Reserve.

Federal Reserve

Open Market Committee (FMOC)

The Federal Reserve SystemThe structure of the Federal Reserve.

Board of Governors Federal Reserve Banks

(Chairman + 6 Members) (12 Presidents)

- Board of Governors

- President of NY Fed

- 4 Fed Bank Presidents

The Federal Reserve SystemThe structure of the Federal Reserve.

Source: http://www.federalreserve.gov/otherfrb.htm

Monetary Policy

1. Setting the reserve requirement.

2. Engaging in open market operations.

3. Adjusting the discount rate.

How the Fed controls the money supply.

Money Creation: Banks

• In effect, banks create money through their borrowing and

lending activity.

• Banks can only loan money depending on its amount of

reserves.

• Required reserves: the specific fraction of deposits that

a bank is required by law to have on hand (often stated

as a required reserve ratio).

• Excess reserves: Total reserves less required reserves.

Some perspective (and terms).

Money Creation: BanksA bank’s simplified balance sheet.

ASSETS LIABILITIES

Deposits

These represent funds that

have to be paid back to

customers in the future.

Reserves and Loans

Reserves are there in

case anyone calls on their

deposits, and banks

generally make money

from interest paid on funds

they lend out.

The Reserve RequirementThe supply of money grows as it flows through the financial system.

BANK OF AMERICA

Assets Liabilities

100 100

CHASE

Assets Liabilities

CITIBANK

Assets Liabilities

The Reserve RequirementThe supply of money grows as it flows through the financial system.

BANK OF AMERICA

Assets Liabilities

20

80

100

CHASE

Assets Liabilities

80 80

CITIBANK

Assets Liabilities

The Reserve RequirementThe supply of money grows as it flows through the financial system.

BANK OF AMERICA

Assets Liabilities

20

80

100

CHASE

Assets Liabilities

16

64

80

CITIBANK

Assets Liabilities

64 64

The Reserve RequirementThe supply of money grows as it flows through the financial system.

BANK OF AMERICA

Assets Liabilities

20

80

100

CHASE

Assets Liabilities

16

64

80

CITIBANK

Assets Liabilities

12.80

51.20

64

And so on throughout the economy...

The Reserve RequirementThe supply of money grows as it flows through the financial system.

BANK OF AMERICA

Assets Liabilities

20

80

100

CHASE

Assets Liabilities

16

64

80

CITIBANK

Assets Liabilities

12.80

51.20

64

12

34

56

And so on throughout the economy...

7

The Money MultiplierThe relationship between the reserve requirement and the money supply.

Note: This is not a multiplier in the sense of GDP multipliers.

Adding up all the new deposits in the economy:

Deposit 1 100.00

Deposit 2 80.00

Deposit 3 64.00

Deposit 4 51.20

.

.

.

.

.

.

TOTAL 500.00

The Money Multiplier:

The amount of new dollars created

by each new dollar deposited in the

financial system.

1

Reserve Requirement

Mathematically:

The Discount Rate

• It is possible for a bank to fall short of its reserve

requirement, in which case it must borrow to make up for

the difference.

• There are two interest rates relevant to banks when they

borrow:

• Federal Funds Rate: The inter-bank loan rate.

(e.g. Bank of America borrowing from Chase Manhattan)

• The Discount Rate: The borrowing rate of the Fed.

(e.g. Bank of America borrowing from the Fed)

Part of monetary policy is setting the rates at which banks borrow.

The Discount Rate

• An increase in the discount rate should contract the money

supply: banks will be inclined to borrow less.

• A decrease in the discount rate should expand the money

supply: banks will be inclined to borrow more.

• Note, however, that the discount rate is seldom used as an

instrument of monetary policy in this way.

• It is usually just used to signal how well the economy is

doing.

• Even if the discount rate is relatively low, the Fed (and

central banks in general) use moral suasion to

discourage borrowing from the discount window.

Part of monetary policy is setting the rates at which banks borrow.

Open Market Operations

• The Treasury can finance a budget deficit (G > T) by

borrowing from the public.

• This is accomplished by issuing government bonds.

• There are two “open markets” for government debt (bonds):

• Primary Market: When the bonds are first issued. The

Fed does not participate in this market.

• Secondary Market: Where bonds already issued are

bought and sold. The Fed participates in these trades.

• By buying (selling) government securities, the Fed

effectively decreases (increases) the money supply.

The Fed controls the money supply by trading in government securities.

Open Market OperationsAn illustration.

The Fed

Suppose the yellow circle

represents the supply of

money in the economy.

If the Fed sells its own

holdings of government

bonds, money flows from

the public to the Fed.

This will cause the

money supply to

contract.

Open Market OperationsAn illustration.

The Fed

Suppose the yellow circle

represents the supply of

money in the economy.

If the Fed sells its own

holdings of government

bonds, money flows from

the public to the Fed.

This will cause the

money supply to

contract.

Open Market OperationsAn illustration.

The Fed

Conversely, the Fed can

also buy government

bonds back from the

public.

This will cause money to

flow from the Fed to the

economy.

As a result, the money

supply will expand.

Open Market OperationsAn illustration.

The Fed

Conversely, the Fed can

also buy government

bonds back from the

public.

As a result, the money

supply will expand.

This will cause money to

flow from the Fed to the

economy.

The Money Supply CurveMoney supply independent of interest rates.

Interest Rate (r)

Money (M)

Ms