TM 13-1 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money is any commodity or...
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Transcript of TM 13-1 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money is any commodity or...
TM 13-1Copyright © 1998 Addison Wesley Longman, Inc.
What is Money?
• Money is any commodity or token that is generally acceptable as the means of payment.
• A means of payment is a method of settling a debt.
TM 13-2Copyright © 1998 Addison Wesley Longman, Inc.
What Money Does?
• functions of Money
1) Medium of exchange
2) Unit of account
3) Store of value
TM 13-3Copyright © 1998 Addison Wesley Longman, Inc.
Measures of Money?
• Official Measures of Money
1) M1 consists of currency and traveler’s checks plus checking deposits.
• Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government
TM 13-4Copyright © 1998 Addison Wesley Longman, Inc.
Measures of Money?
• Official Measures of Money
2) M2 consists of M1 plus saving deposits and time deposits
TM 13-5Copyright © 1998 Addison Wesley Longman, Inc.
Measures of Money?
• Official Measures of Money
3) M3 consists of M2 plus large-scale time deposits and term deposits
TM 13-6Copyright © 1998 Addison Wesley Longman, Inc.
Two Measures of Money
TM 13-7Copyright © 1998 Addison Wesley Longman, Inc.
Financial Intermediaries
• Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.
TM 13-8Copyright © 1998 Addison Wesley Longman, Inc.
Financial Intermediaries
• Four Types of Financial Intermediaries
1) Commercial banks
2) Savings and loan associations
3) Savings banks and credit unions
4) Money market mutual funds
TM 13-9Copyright © 1998 Addison Wesley Longman, Inc.
Financial Intermediaries
• Commercial Banks
• A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.
TM 13-10Copyright © 1998 Addison Wesley Longman, Inc.
Financial Intermediaries
• Commercial Banks
• Their balance sheet is described by the following formula:
Liabilities + Net Worth = Assets
TM 13-11Copyright © 1998 Addison Wesley Longman, Inc.
Financial Intermediaries
• Reserves and Loans
• Banks divide their funds into two parts:• Reserves are cash in a bank’s vault plus its deposits
at Federal Reserve banks
• Loans
TM 13-12Copyright © 1998 Addison Wesley Longman, Inc.
Financial Intermediaries
• Three Types of Assets Held by Banks
1) Liquid assets are U.S. government Treasury bills and commercial bills
2) Investment securities are longer-term U.S. government bonds and other bonds
3) Loans are commitments of fixed amounts of money for agreed- upon periods of time
TM 13-13Copyright © 1998 Addison Wesley Longman, Inc.
Financial Intermediaries (FI)
• The Economic Functions of FI
1) Creating Liquidity
2) Minimizing the cost of borrowing
3) Minimizing the cost of monitoring borrowers
4) Pooling Risk
TM 13-14Copyright © 1998 Addison Wesley Longman, Inc.
How Banks Create Money
• Reserves: Actual and Required
• The reserve ratio is the fraction of a bank’s total deposits that are held in reserves.
• The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold.
• Excess reserves are actual reserves minus required reserves.
TM 13-15Copyright © 1998 Addison Wesley Longman, Inc.
How Banks Create Money
• Creating Deposits by Making loans in a One-Bank Economy
Let’s see an example of howbanks create money.
TM 13-16Copyright © 1998 Addison Wesley Longman, Inc.
Reserves $100 Deposits $400
Loans $300
Total $400 Total $400
Creating Money at theOne-and-Only Bank
Balance sheet on January 1
Assets(millions of dollars)
Liabilities(millions of dollars)
TM 13-17Copyright © 1998 Addison Wesley Longman, Inc.
Reserves $101 Deposits $401
Loans $300
Total $401 Total $401
Creating Money at theOne-and-Only Bank
Balance sheet on January 2
Assets(millions of dollars)
Liabilities(millions of dollars)
TM 13-18Copyright © 1998 Addison Wesley Longman, Inc.
Reserves $101 Deposits $404
Loans $303
Total $404 Total $404
Creating Money at theOne-and-Only Bank
Balance sheet on January 3
Assets(millions of dollars)
Liabilities(millions of dollars)
TM 13-19Copyright © 1998 Addison Wesley Longman, Inc.
How Banks Create Money
• The Deposit Multiplier
reservesinChange
depositsinChangemultiplierDeposit
TM 13-20Copyright © 1998 Addison Wesley Longman, Inc.
How Banks Create Money
• Creating Deposits by Making Loans with Many Banks
Let’s see how the
banking system creates money
TM 13-21Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tallyReserves Loans Deposits
TM 13-22Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tally
Deposit$100,000
Reserves Loans Deposits
TM 13-23Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tally
Deposit$100,000
Reserves Loans Deposits
$25,000
$75,000 $25,000
$75,000 $100,000Loan
$75,000Reserve$25,000
TM 13-24Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence
Deposit$100,000
Loan$75,000
Deposit$75,000
Reserve$25,000
The running tallyReserves Loans Deposits
$25,000
$75,000 $25,000
$75,000 $100,000
TM 13-25Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tally
Deposit$100,000
Reserves Loans Deposits
$25,000
$75,000 $25,000
$75,000 $100,000Loan
$75,000
Deposit$75,000
Reserve$25,000
Loan$56,250
Reserve$18,750 $43,750 $131,250 $175,000
TM 13-26Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence
Deposit$56,250
The running tallyReserves Loans Deposits
TM 13-27Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tallyReserves Loans Deposits
$43,750 $131,250 $175,000
Deposit$56,250
Loan$42,187
Reserve$14,063 $57,813 $173,437 $231,250
TM 13-28Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tallyReserves Loans Deposits
Deposit$56,250
Loan$42,187
Reserve$14,063
Deposit$42,187
$43,750 $131,250 $175,000
$57,813 $173,437 $231,250
TM 13-29Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tallyReserves Loans Deposits
$68,360 $205,077 $273,437
Loan$31,640
Reserve$10,547
TM 13-30Copyright © 1998 Addison Wesley Longman, Inc.
The Multiple Creationof Bank Deposits
The sequence The running tallyReserves Loans Deposits
$68,360 $205,077 $273,437
Loan$31,640
Reserve$10,547
andso on...
$100,000 $300,000 $400,000
TM 13-31Copyright © 1998 Addison Wesley Longman, Inc.
The Fed controls the money supply by adjusting the reserves of the banking system.
TM 13-32Copyright © 1998 Addison Wesley Longman, Inc.
The Fed controls the money supply by adjusting the reserves of the banking system. These reserves are controlled by three tools available to the Fed.
TM 13-33Copyright © 1998 Addison Wesley Longman, Inc.
1) Required reserve ratios
TM 13-34Copyright © 1998 Addison Wesley Longman, Inc.
1) Required reserve ratios
2) Discount rate
TM 13-35Copyright © 1998 Addison Wesley Longman, Inc.
1) Required reserve ratios
2) Discount rate
3) Open market operations
TM 13-36Copyright © 1998 Addison Wesley Longman, Inc.
• Required Reserve Ratios
• The Fed determines a required reserve ratio for each type of deposit.• In 1997, banks were required to keep 3 percent of
checking deposits up to $49 million and 10 percent of deposits in excess of $49 million.
• Other deposits had no reserve requirement.
TM 13-37Copyright © 1998 Addison Wesley Longman, Inc.
• Discount Rate
• The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks.
TM 13-38Copyright © 1998 Addison Wesley Longman, Inc.
• Open Market Operations
• Open market operations are the purchase or sale of government securities by the Federal Reserve System on the open market.
TM 13-39Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• We are going to study the effect the money supply has on real GDP, the price level, and the inflation rate.
TM 13-40Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• The Short-Run Effects of a Change in the Quantity of Money
• Let’s study how a change in the quantity of money effects these factors by examining the aggregate supply-aggregate demand model.
TM 13-41Copyright © 1998 Addison Wesley Longman, Inc.
Short-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
120
107
6.8 7.4
TM 13-42Copyright © 1998 Addison Wesley Longman, Inc.
Short-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
AD0
6.6 7.0 7.2 7.6
120
107
6.8 7.4
LAS
SAS
AD1
TM 13-43Copyright © 1998 Addison Wesley Longman, Inc.
Short-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
AD0
6.6 7.0 7.2 7.6
120
107
6.8 7.4
LAS
SAS
AD1
TM 13-44Copyright © 1998 Addison Wesley Longman, Inc.
Short-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
120
107
6.8 7.4
LAS
SAS
AD1
TM 13-45Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
121
6.8 7.4
TM 13-46Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
121
6.8 7.4
LAS
AD1
SAS1
TM 13-47Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
121
6.8 7.4
LAS
113
AD1
SAS1
AD2
TM 13-48Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
121
6.8 7.4
LAS
113
AD1
SAS1
AD2
TM 13-49Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
121
6.8 7.4
LAS
113
AD1
SAS1
AD2
SAS2
TM 13-50Copyright © 1998 Addison Wesley Longman, Inc.
Long-Run Effects ofChange in Quantity of Money
Real GDP (trillions of 1992 dollars)
Pri
ce le
vel
(GD
P d
efla
tor,
199
2 =
100
)
100
110
130
140
6.6 7.0 7.2 7.6
121
6.8 7.4
LAS
113
AD2
SAS2
TM 13-51Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives (cont.)
• Explain how banks create money
• Explain why the quantity of money is an important economic magnitude
• Explain the quantity theory of money
TM 13-52Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• The Quantity Theory of Money
• The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.
• This theory is based upon the velocity of circulation and the equation of exchange.
TM 13-53Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• The Quantity Theory of Money
• The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.
TM 13-54Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• GDP equals the price level (P) times real GDP (Y), or:
GDP = PY
TM 13-55Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• Make the quantity of money M, and the velocity of circulation V is determined by:
V = PY/M
TM 13-56Copyright © 1998 Addison Wesley Longman, Inc.
The Velocity of Circulation in the United States: 1930–1996
TM 13-57Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or
MV=PY
TM 13-58Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• We can convert the equation of exchange into the quantity theory of money by making two assumptions:
1) The velocity of circulation is not influenced by the quantity of money.
2) Potential GDP is not influenced by the quantity of money.
TM 13-59Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level.
TM 13-60Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• This can be shown by using the equation of exchange to solve for the price level.
P = (V/Y)M
TM 13-61Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:
MYVP )/(
TM 13-62Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• Dividing this equation by an earlier one, P = (V/Y)M, gives us
MMPP //
TM 13-63Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money.
• This gives us the quantity theory of money:
• In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.
TM 13-64Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• The AS-AD model predicts the same outcome as the quantity theory of money.
• It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.
TM 13-65Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• Historical Evidence on the Quantity Theory of Money
• The data are broadly consistent with the quantity theory of money, but the relationship is not precise.
• The relationship is stronger in the long run than in the short run.
TM 13-66Copyright © 1998 Addison Wesley Longman, Inc.
Money Growth andInflation in the United States
TM 13-67Copyright © 1998 Addison Wesley Longman, Inc.
Money Growth andInflation in the United States
TM 13-68Copyright © 1998 Addison Wesley Longman, Inc.
Money Growth andInflation in the World Economy
TM 13-69Copyright © 1998 Addison Wesley Longman, Inc.
Money Growth andInflation in the World Economy
TM 13-70Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• Correlation, Causation, and Other Influences
• The evidence shows that money growth and inflation are correlated.
TM 13-71Copyright © 1998 Addison Wesley Longman, Inc.
Money, Real GDP, andthe Price Level
• Correlation, Causation, and Other Influences
• This does not represent causation.• Does money growth cause inflation, or does
inflation cause money growth?
• Does some other factor cause inflation (deficit spending)?