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1.
10 MONEY AND PRICES
IN THE LONG RUN
2.
The Monetary
System 29 Copyright © 2004 South-Western
3.
THE MEANING OF
MONEY • Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Copyright © 2004 South-Western
4.
The Functions of
Money • Money has three functions in the economy: • Medium of exchange • Unit of account • Store of value Copyright © 2004 South-Western
5.
The Functions of
Money • Medium of Exchange • A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. • A medium of exchange is anything that is readily acceptable as payment. Copyright © 2004 South-Western
6.
The Functions of
Money • Unit of Account • A unit of account is the yardstick people use to post prices and record debts. • Store of Value • A store of value is an item that people can use to transfer purchasing power from the present to the future. Copyright © 2004 South-Western
7.
The Functions of
Money • Liquidity • Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange. Copyright © 2004 South-Western
8.
The Kinds of
Money • Commodity money takes the form of a commodity with intrinsic value. • Examples: Gold, silver, cigarettes. • Fiat money is used as money because of government decree. • It does not have intrinsic value. • Examples: Coins, currency, check deposits. Copyright © 2004 South-Western
9.
Money in the
U.S. Economy • Currency is the paper bills and coins in the hands of the public. • Demand deposits are balances in bank accounts that depositors can access on demand by writing a check. Copyright © 2004 South-Western
10.
Figure 1 Money
in the U.S. Economy Billions of Dollars M2 $5,455 • Savings deposits • Small time deposits • Money market mutual funds • A few minor categories ($4,276 billion) M1 $1,179 • Demand deposits • Everything in M1 • Traveler’s checks ($1,179 billion) • Other checkable deposits ($599 billion) • Currency ($580 billion) 0 Copyright©2003 Southwestern/Thomson Learning
11.
CASE STUDY: Where
Is All The Currency? • In 2001 there was about $580 billion of U.S. currency outstanding. • That is $2,734 in currency per adult. • Who is holding all this currency? • Currency held abroad • Currency held by illegal entities Copyright © 2004 South-Western
12.
THE FEDERAL RESERVE
SYSTEM • The Federal Reserve (Fed) serves as the nation’s central bank. • It is designed to oversee the banking system. • It regulates the quantity of money in the economy. Copyright © 2004 South-Western
13.
THE FEDERAL RESERVE
SYSTEM • The Fed was created in 1914 after a series of bank failures convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system. Copyright © 2004 South-Western
14.
THE FEDERAL RESERVE
SYSTEM • The Structure of the Federal Reserve System: • The primary elements in the Federal Reserve System are: • 1) The Board of Governors • 2) The Regional Federal Reserve Banks • 3) The Federal Open Market Committee Copyright © 2004 South-Western
15.
The Fed’s Organization •
The Fed is run by a Board of Governors, which has seven members appointed by the president and confirmed by the Senate. • Among the seven members, the most important is the chairman. • The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees. Copyright © 2004 South-Western
16.
The Fed’s Organization •
The Board of Governors • Seven members • Appointed by the president • Confirmed by the Senate • Serve staggered 14-year terms so that one comes vacant every two years. • President appoints a member as chairman to serve a four-year term. Copyright © 2004 South-Western
17.
The Fed’s Organization •
The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks. Copyright © 2004 South-Western
18.
The Fed’s Organization •
The Federal Reserve Banks • Twelve district banks • Nine directors • Three appointed by the Board of Governors. • Six are elected by the commercial banks in the district. • The directors appoint the district president, which is approved by the Board of Governors. Copyright © 2004 South-Western
19.
The Federal Reserve
System Copyright©2003 Southwestern/Thomson Learning
20.
The Fed’s Organization •
The Federal Reserve Banks • The New York Fed implements some of the Fed’s most important policy decisions. Copyright © 2004 South-Western
21.
The Fed’s Organization •
The Federal Open Market Committee (FOMC) • Serves as the main policy-making organ of the Federal Reserve System. • Meets approximately every six weeks to review the economy. Copyright © 2004 South-Western
22.
The Fed’s Organization •
The Federal Open Market Committee (FOMC) is made up of the following voting members: • The chairman and the other six members of the Board of Governors. • The president of the Federal Reserve Bank of New York. • The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis). Copyright © 2004 South-Western
23.
The Fed’s Organization •
Monetary policy is conducted by the Federal Open Market Committee. • Monetary policy is the setting of the money supply by policymakers in the central bank • The money supply refers to the quantity of money available in the economy. Copyright © 2004 South-Western
24.
The Federal Open
Market Committee • Three Primary Functions of the Fed • Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. • Acts as a banker’s bank, making loans to banks and as a lender of last resort. • Conducts monetary policy by controlling the money supply. Copyright © 2004 South-Western
25.
The Federal Open
Market Committee • Open-Market Operations • The money supply is the quantity of money available in the economy. • The primary way in which the Fed changes the money supply is through open-market operations. • The Fed purchases and sells U.S. government bonds. Copyright © 2004 South-Western
26.
The Federal Open
Market Committee • Open-Market Operations • To increase the money supply, the Fed buys government bonds from the public. • To decrease the money supply, the Fed sells government bonds to the public. Copyright © 2004 South-Western
27.
BANKS AND THE
MONEY SUPPLY • Banks can influence the quantity of demand deposits in the economy and the money supply. Copyright © 2004 South-Western
28.
BANKS AND THE
MONEY SUPPLY • Reserves are deposits that banks have received but have not loaned out. • In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. Copyright © 2004 South-Western
29.
BANKS AND THE
MONEY SUPPLY • Reserve Ratio • The reserve ratio is the fraction of deposits that banks hold as reserves. Copyright © 2004 South-Western
30.
Money Creation with
Fractional-Reserve Banking • When a bank makes a loan from its reserves, the money supply increases. • The money supply is affected by the amount deposited in banks and the amount that banks loan. • Deposits into a bank are recorded as both assets and liabilities. • The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. • Loans become an asset to the bank. Copyright © 2004 South-Western
31.
Money Creation with
Fractional-Reserve Banking • This T-Account shows a bank that… • accepts deposits, First National Bank • keeps a portion Assets Liabilities as reserves, • and lends out Reserves Deposits the rest. $10.00 $100.00 • It assumes a Loans reserve ratio $90.00 of 10%. Total Assets Total Liabilities $100.00 $100.00 Copyright © 2004 South-Western
32.
Money Creation with
Fractional-Reserve Banking • When one bank loans money, that money is generally deposited into another bank. • This creates more deposits and more reserves to be lent out. • When a bank makes a loan from its reserves, the money supply increases. Copyright © 2004 South-Western
33.
The Money Multiplier •
How much money is eventually created in this economy? Copyright © 2004 South-Western
34.
The Money Multiplier •
The money multiplier is the amount of money the banking system generates with each dollar of reserves. Copyright © 2004 South-Western
35.
The Money Multiplier
First National Bank Second National Bank Assets Liabilities Assets Liabilities Reserves Deposits Reserves Deposits $10.00 $100.00 $9.00 $90.00 Loans Loans $90.00 $81.00 Total Assets Total Liabilities Total Assets Total Liabilities $100.00 $100.00 $90.00 $90.00 Money Supply = $190.00! Copyright © 2004 South-Western
36.
The Money Multiplier •
The money multiplier is the reciprocal of the reserve ratio: M = 1/R • With a reserve requirement, R = 20% or 1/5, • The multiplier is 5. Copyright © 2004 South-Western
37.
The Fed’s Tools
of Monetary Control • The Fed has three tools in its monetary toolbox: • Open-market operations • Changing the reserve requirement • Changing the discount rate Copyright © 2004 South-Western
38.
The Fed’s Tools
of Monetary Control • Open-Market Operations • The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: • When the Fed buys government bonds, the money supply increases. • The money supply decreases when the Fed sells government bonds. Copyright © 2004 South-Western
39.
The Fed’s Tools
of Monetary Control • Reserve Requirements • The Fed also influences the money supply with reserve requirements. • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. Copyright © 2004 South-Western
40.
The Fed’s Tools
of Monetary Control • Changing the Reserve Requirement • The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. • Increasing the reserve requirement decreases the money supply. • Decreasing the reserve requirement increases the money supply. Copyright © 2004 South-Western
41.
The Fed’s Tools
of Monetary Control • Changing the Discount Rate • The discount rate is the interest rate the Fed charges banks for loans. • Increasing the discount rate decreases the money supply. • Decreasing the discount rate increases the money supply. Copyright © 2004 South-Western
42.
Problems in Controlling
the Money Supply • The Fed’s control of the money supply is not precise. • The Fed must wrestle with two problems that arise due to fractional-reserve banking. • The Fed does not control the amount of money that households choose to hold as deposits in banks. • The Fed does not control the amount of money that bankers choose to lend. Copyright © 2004 South-Western
43.
Summary • The term
money refers to assets that people regularly use to buy goods and services. • Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value. • Commodity money is money that has intrinsic value. • Fiat money is money without intrinsic value. Copyright © 2004 South-Western
44.
Summary • The Federal
Reserve, the central bank of the United States, regulates the U.S. monetary system. • It controls the money supply through open- market operations or by changing reserve requirements or the discount rate. Copyright © 2004 South-Western
45.
Summary • When banks
loan out their deposits, they increase the quantity of money in the economy. • Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect. Copyright © 2004 South-Western
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