Chapter 9

1. Chapter 9 The Financial System, Money, and Prices

2. Learning Objectives • Discuss the three functions of money and how money is measured • Analyze how the lending behavior of commercial banks affects the money supply • Understand the central bank control of the money supply and its relation to inflation in the long run

3. Money • Money is any asset that can be used in making purchases • Examples include coins and currency, checking account balances, and traveler's checks • Shares of stock are not money • Money has three principal uses • Medium of exchange • Unit of account • Store of value • Money makes barter unnecessary • Barter is trading goods directly

4. Measuring Money • Definitions of money range from narrow to broad

5. Commercial Banks Create Money • Republic of Gorgonzola begins with no banking system • Government issues 1 million guilders • Banks are created to store cash • Payments are made by withdrawing cash or writing checks • Without interest, banks earn profits by charging depositors fees • Citizens prefer bank deposits to cash for making transactions

6. Consolidated Bank Balance Sheet – Part 1 • All guilders (g) are deposited • Bank reserves are cash or similar assets held by banks • Used to meet depositors' withdrawals and payments • Gorgonzola's banks have 100% reserves • 100% reserve banking is when banks' reserves equal 100% of their deposits

7. Bank Reserves • Cash in a bank's vault is not part of the money supply • Unavailable for payments • Bank deposits available for use in transactions are part of the money supply • Depositing a $100 bill in your checking account does not change the money supply • Bankers realize that inflows and outflows from vaults leave some guilders unused • Only 10% of deposits are needed for transactions • 90% can be lent to borrowers for a fee -- interest

8. Consolidated Bank Balance Sheet – Part 2 • Currency held in the vault is the bank reserves • The reserve – deposit ratio is bank reserves divided by total deposits • Fractional reserve banking system holds less bank reserves than deposits • The reserve – deposit ratio is less than 100%

9. Consolidated Bank Balance Sheet – Part 3 • Farmers borrow 900,000 guilders to buy supplies • Farmers spend the 900,000 guilders which are then deposited in the banks • Bank deposits are the entire money supply • Loan of 900,000 guilders increased the money supply by 900,000 guilders • Banks are again holding excess reserves on deposits of 1,900,000 guilders

10. Consolidated Bank Balance Sheet – Part 4 • With deposits of 1,900,000 guilders and a reserve – deposit ratio of 10%, banks want only 190,000 guilders in reserves • Currently holding 1,000,000 guilders • Loan 810,000 guilders • Loan are spent and re-deposited • Excess reserves are created and re-loaned

11. Consolidated Bank Balance Sheet – The End • Expansion of loans and deposits stops when reserves are 10% of deposits • 1,000,000 guilders available as reserves • Deposits stabilize at 10,000,000 guilders • Beginning with 1,000,000 guilders in cash, the money supply is now 10,000,000 guilders

12. Money Creation • With 10% reserves, each guilder supports 10 guilders in deposits • The general case of money creation with fractional reserve banking is • Solving for bank deposits we get Bank reserves Bank deposits Bank reserves Desired reserve-deposit ratio = Desired reserve-deposit ratio Bank deposits =

13. Money Supply with Currency and Deposits • Gorgonzola residents hold 500,000 guilders as currency • Deposit 500,000 guilders in the banks • Reserve-deposit ratio = 10% • Bank deposits = 500,000 / 0.10 = 5,000,000 guilders • Money supply = 500,000 cash + 5,000,000 deposits = 5,500,000 guilders Bank reserves Desired reserve-deposit ratio Money supply = Currency held by public +

14. Bank Panics, 1930 - 1933 • One-third of the banks closed • Increased the severity of the Great Depression • Difficult for small businesses and consumers to get credit • Money supply decreased • With no federal deposit insurance, people held cash • Feared banks would close and they would lose their deposits • Holding cash reduced banks' reserves • Lower reserves decreases the money supply by a multiple of the change in reserves

15. Bank Panics, 1930 - 1933 • Banks increased their reserve – deposit ratio • Further decreased the money supply

16. Deposit Insurance • Congress created deposit insurance in 1934 • Deposits of less than $100,000 will be repaid even if the bank is bankrupt • Decreases incentive to withdraw funds on rumors • No significant bank panics since 1934 • With less risk, depositors pay less attention to whether banks are making prudent investments • In the 1980s, many savings and loan associations went bankrupt • Cost the taxpayers hundreds of billions of dollars

17. The Federal Reserve System • The Fed is the central bank of the US • Responsible for monetary policy and the oversight and regulation of financial markets • Monetary policy is deciding and managing the size of the nation's money supply • Money supply is controlled indirectly • Open-market purchase of government bonds from the pubic by the Fed increases bank reserves and the money supply • Open-market sale of government bonds by the Fed to the public decreases reserves and money supply

18. Open Market Operations • When the Fed purchases a bond from the public • Fed pays bond holder with new money • Receipts are deposited and this leads to a multiple expansion of the money supply • When the Fed sells a bond to the public • Bondholder pays with checking funds • Bank reserves decrease and this leads to a multiple contraction of the money supply

19. Increasing the Money Supply • An economy has 1,000 shekels in currency and bank reserves of 200 shekels • Reserve-deposit ratio = 0.2 • Money supply = 1,000 + (200 / 0.2) = 2,000 shekels • Central bank pays 100 shekels for a bond held by the public • Assume that all 100 shekels are deposited • Money supply = 1,000 + (300/ 0.2) = 2,500 shekels • 100 shekel increase in reserves leads to a 500 shekel increase in the money supply

20. Money and Prices • In the long run, the amount of money circulating and the level of prices are closely linked • Sustained high inflation rates occur with a comparably high growth rate of the money supply

21. Velocity of Money (V) • Velocity is the speed money changes hands in transaction for final goods and services • Nominal GDP is the price level (P) times real GDP (Y) • M is the money supply Nominal GDP Money supply Velocity = PY M V =

22. Velocity in the US, 2007 • M1 = $1,364.2 billion • M2 = $7,447.1 billion • Nominal GDP = $13,843.0 billion • Using M1, velocity is 10.15 • Using M2, velocity is 1.86 • Velocity is determined by a number of factors including technology such as ATMs and debit cards $13,843.0 1,364.2 V = = 10.15 $13,843.0 7, 447.1 V = = 1.86

23. Money and Inflation in the Long Run • Quantity equation states MV = PY • Restatement of the velocity definition • The quantity equation relates the money supply to price levels • Suppose velocity and real GDP are constant • The quantity equation becomes • An increase in the money supply by a given percentage would increase prices by the same percentage M V = P Y V and Y, respectively

24. Approximating a Percentage Change M V = P Y % change in (M V) = % change in (P Y) • The percentage change in a product is the sum of the percentage changes in each variable • Consequently % change in M + % change in V ≈ % change in P + % change in Y • If the M grows 4% per year and V grows 1% per year, nominal GDP (P Y) grows approximately 5% per year • If Y grows 3% per year, then the percentage change in price is approximately 2% per year

25. The Financial System, Money, and Prices Quantity Equation Financial System Open Market Operations Money Stocks Diversification Bonds Federal Reserve System Reserves Banks