Chapter 31: Money and the Monetary System

• What the main functions of money are and what makes something a good choice for money. • How to explain the concept of fractionalreserve banking and the money multiplier. • What role the central bank plays and what the Federal Reserve’s (Fed) dual mandate is. • How the Fed conducts monetary policy. • How monetary policy affects interest rates, the money supply, and the broader economy.

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11© 2014 by McGraw-Hill Education Chapter 31 Money and the Monetary System 2© 2014 by McGraw-Hill Education • What the main functions of money are and what makes something a good choice for money. • How to explain the concept of fractional- reserve banking and the money multiplier. • What role the central bank plays and what the Federal Reserve’s (Fed) dual mandate is. • How the Fed conducts monetary policy. • How monetary policy affects interest rates, the money supply, and the broader economy. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • Money is the set of all assets that are regularly used to directly purchase goods and services. • Money serves three main functions: 1. Store of value: Money represents a certain amount of purchasing power. 2. Medium of exchange: Money can be used to purchase goods and services. – A barter system is where people directly offer a good or service for another good or service. 3. Unit of account: Money provides a standard unit of comparison. What is money? Functions of money 24© 2014 by McGraw-Hill Education • There are two basic considerations that make certain money better than others. • Stability of value: – Early versions of money generally took the form of a physical material that was durable and had intrinsic value. – Money does not need intrinsic value to maintain stability. • Convenience: – Technology has allowed for the development of more convenient forms of money. • For example, paper money is more convenient than gold coins. What makes for good money? 5© 2014 by McGraw-Hill Education • Any form of money that can be legally exchanged into a fixed amount of an underlying commodity is commodity-backed money. – The most common underlying commodity is gold. • Money created by rule, without any commodity backing it, is fiat money. – U.S. currency is backed only by the trust that the government will keep the value of money relatively constant. Commodity-backed money versus fiat money 6© 2014 by McGraw-Hill Education • Paper money made it possible for banks to create money through a process called fractional-reserve banking. • The primary way that banks earn money is through lending a fraction of deposited funds and collecting interest on those loans. – Demand deposits are funds held in bank accounts that can be withdrawn by depositors at any time, without advance notice. Banks and the money-creation process 37© 2014 by McGraw-Hill Education • Reserves refers to the money that banks keep on hand. • The reserve ratio is the ratio of the total amount of demand deposits at the bank to the amount kept as cash reserves. – Required reserves is the amount that a bank is legally required to keep on hand. – Excess reserves is any additional amount that a bank chooses to keep beyond the required reserves. Banks and the money-creation process 8© 2014 by McGraw-Hill Education The money creation process occurs through banks repeatedly accepting deposits and lending out a fraction of the deposits. Banks and the money-creation process Original deposit of 1,000 gold coins Total deposits = 1,000 gold coins + 900 gold coins = 1,900 gold coins Deposit of 900 more gold coins 100 gold coins held on reserve (10% of original deposit) 900 gold coins loaned out (90% of original deposit) One gold coin 9© 2014 by McGraw-Hill Education Assets Liabilities The bank loans out 90% of its new deposits Assets Liabilities The loan is deposited in the bank Assets Liabilities Bank makes its first loan Assets Liabilities Original deposit The above process increases money by $900. Banks and the money-creation process Loan: $900 Required reserves: $100 Deposit: $1,000 Loan: $900 New cash deposit: $900 Required reserves: $100 Cash: $1,000 Deposit: $1,000 Deposit: $1,900 Loans: $1,710 Required reserves: $190 Deposit: $1,900 A simple way to account for a bank’s transactions is by using T-account formatting to record changes in banks assets and liabilities. 410© 2014 by McGraw-Hill Education A bank accepts a $1,000 deposit. If the bank has a reserve ratio of 20% and loans out the rest, find the change in assets and liabilities. Active Learning: Money creation Assets Liabilities Loans: $2,000 Required reserves $500 Deposit: $2,500 11© 2014 by McGraw-Hill Education • The money creation process continues with repeated cycles of lending and depositing of funds. • The money multiplier is the ratio of money created by the lending activities of the banking system to the money created by the central bank: Money multiplier = ଵ ୖୣୱୣ୰୴ୣ ୰ୟ୲୧୭ • In a fractional-reserve banking system, banks keep less than 100% of their deposits on reserves. Banks and the money-creation process 12© 2014 by McGraw-Hill Education Use the money multiplier equation to fill in the blanks in the following table. Active Learning: The money multiplier Situation Reserve ratio Money Multiplier A 10% B 5% C 5 513© 2014 by McGraw-Hill Education • The money supply is the amount of money available in the economy. – The money supply is managed by the Fed. • The Fed classifies different types of money by their liquidity. – The monetary base includes cash and bank reserves, sometime referred to as hard money. – M1 includes cash plus checking account balances. – M2 includes M1 plus savings accounts and other financial instruments. Measuring money 14© 2014 by McGraw-Hill Education Hard money M2 0 1 2 3 4 5 6 7 8 9 10 1984 1989 1994 1999 2004 2009 Trillions of U.S. dollars Hard money, M1, and M2 over time • M1 indicates liquidity. • M2 indicates savings. • M2 is a measure of the money multiplier when compared to the monetary base. M1 Each measure provides a distinct understanding of the financial system. Measuring money 15© 2014 by McGraw-Hill Education • The central bank is the institution responsible for managing the nation’s money supply and coordinating the banking system. • In the U.S., the central bank is the Federal Reserve, which has been mandated by Congress to conduct monetary policy to perform two essential functions: 1. Manage the money supply. 2. Act as a lender of last resort. • Monetary policy refers to the actions made by the central bank to manage the money supply. Managing the money supply 616© 2014 by McGraw-Hill Education The Federal Reserve System has a seven-member Board of Governors and twelve regional banks that collectively act as the central bank of the U.S. Managing the money supply San Francisco Dallas Kansas City Chicago St. Louis Atlanta Richmond Cleveland Philadelphia Boston NewYork Board of Governors, ashington D.C. Minneapolis W 17© 2014 by McGraw-Hill Education • In addition, five of the twelve regional bank presidents serve on the Federal Open Market Committee, or FOMC. – Carries full responsibility for setting the overall direction of monetary policy and guiding the money supply. • The Fed has a twin or dual mandate: – Ensuring price stability: Enacting monetary policy that meets the needs of the economy while keeping prices constant over time. – Maintaining full employment: Enacting monetary policy that keeps the economy strong and stable. Managing the money supply 18© 2014 by McGraw-Hill Education • The Fed achieves these mandates by managing the money supply through three main tools. 1. The reserve requirement is the amount of money banks must hold in reserve. 2. The discount window is the lending facility that allows banks to borrow reserves from the Fed. • The discount rate is the interest rate charged by the Fed for loans through the discount window. 3. Open-market operations are sales or purchases of government bonds by the Fed to or from banks on the open market. Tools of monetary policy 719© 2014 by McGraw-Hill Education • These transactions directly impact the money supply. – Contractionary monetary policy is when money supply is decreased to lower aggregate demand. – Expansionary monetary policy is when money supply is increased to raise aggregate demand. • Open market operations also affect the inter-bank lending market, the federal funds market. – The federal funds rate is the interest rate at which banks lend reserves to one another. • The Fed affects the federal funds rate through changes in the supply of reserves by conducting contractionary and expansionary monetary policy. Tools of monetary policy 20© 2014 by McGraw-Hill Education • The liquidity-preference model refers to the idea that the quantity of money people want to hold is a function of the interest rate. – This means the money demand curve slopes downward. – The Fed sets the money supply, which means the money supply curve is set by monetary policy. The economic effects of monetary policy Monetary demand Monetary supply r* Q* Interest rate, r Quantity of money The liquidity-preference model • Monetary policy primarily influences the economy through changes in the interest rate. • Changes in the interest rate, in turn, affect the appeal of borrowing and lending, which can have significant impacts on the economy. 21© 2014 by McGraw-Hill Education Interest rate, r Quantity of money MD MS* Shifts in the money supply curve The liquidity-preference model explains how the Fed’s actions can change interest rates. The economic effects of monetary policy Qe MSc MSe rc Qc r* Q* re • Expansionary monetary policy results in a higher quantity of money and lower interest rates. • Contractionary monetary policy results in a lower quantity of money and higher interest rates. 822© 2014 by McGraw-Hill Education For each of the following situations, indicate the effect (increase or decrease) on the money supply and interest rate. Active Learning: The money supply Situation Change in money supply Change in interest rate The Federal Reserve conducts open-market bond purchases. The Federal Reserve sells government bonds on the open market. 23© 2014 by McGraw-Hill Education Expansionary monetary policy AD2 Interest rate, r Quantity of money Money demand MS1 Q1 r1 Expansionary monetary policy Y2 P2 Price level Real GDP LRAS AD1 Y1 SRAS Expansionary monetary policy and the AD/AS model P1 MS2 Q2 r2 • During a recession, expansionary monetary policy decreases the interest rate. • Cheaper to borrow and less rewarding to save money. • The aggregate demand curve shifts out. • Price and output increase. 24© 2014 by McGraw-Hill Education Interest rate, r Quantity of money MD MS1 Q1 Contractionary monetary policy MS2 Q2 r2 Contractionary monetary policy • During overheating, contractionary monetary policy increases the interest rate. • More expensive to borrow and encourages saving. • The aggregate demand curve shifts in. • Prices and output decrease. r1 1 2 AD2 Contractionary monetary policy and the AD/AS model Price level Real GDP LRAS P Y1 SRAS AD1 P Y2 925© 2014 by McGraw-Hill Education • The Fed faces time lags and imperfect information. – A few months can pass before the Fed’s actions make their impact. – Mistiming of monetary policy could make economic conditions worse. The economic effects of monetary policy Challenges Advantages • The Fed does not have to wait for politicians to come to a policy consensus. • The Fed is made up of prominent economic policy-makers. – It is their job to make sure they fully understand the nuances of the overall economy. Analyzing the use of monetary policy shows how policy can work in ideal cases, but it is rare for the world to work so cleanly. 26© 2014 by McGraw-Hill Education • One concern is how the lending market is affected during times of expansionary monetary policy. • That is, it may be that extra borrowing causes a shortage of loanable funds, as the demand from borrowers increases and the supply from savers decreases. • This leads to two very different models of the way the world works: 1. The Federal Reserve determines the interest rate by managing the supply and demand for money. 2. The market as a whole determines the interest rate by the interaction of savers and borrowers. Two interconnected markets 27© 2014 by McGraw-Hill Education These two models are connected by the dynamics of the economy. Two interconnected markets Interest rate Quantity of dollars Market for loanable funds Savings 2 Investment Savings 1 r1 Q 1 Q 2 r2 MD MS2 Interest rate Quantity of dollars Q 1 r1 MS1 Liquidity-preference model r2 Q 2 • When the Fed acts to lower interest rates, it spurs borrowing and increases output in the economy. • Some of this increase in output is saved. • Shifts the supply of loanable funds outward to equalize interest rates between models. 10 28© 2014 by McGraw-Hill Education • The three main functions of money are a store of value, a medium of exchange, and a unit of account. • Money needs to have stability of value to be convenient. • Banks create money by lending through the fractional reserve banking. • The money multiplier is the ratio of money created by the lending activities to the money created by the central bank. Summary 29© 2014 by McGraw-Hill Education • The Fed classifies different types of money by their liquidity. – M1 includes hard money plus checkable deposits. – M2 includes M1 plus money in savings accounts and CDs. • The central bank maintains the money supply and coordinates the banking system. • The Federal Reserve has a dual mandate: – Ensure price stability. – Maintain full employment. Summary 30© 2014 by McGraw-Hill Education • Monetary policy includes changing the reserve requirement, lending through the discount window, and engaging in open-market operations. • The liquidity-preference model explains that the demand for money is a function of the interest rate. • The Fed may want to engage in expansionary or contractionary monetary policy depending on the economic circumstances. Summary