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10 MONEY AND PRICES IN THE LONG RUN Chapter 29 The Monetary System

10 MONEY AND PRICES IN THE LONG RUN Chapter 29 The Monetary System. 29.1 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. 29.1.1 The Functions of Money. Money has three functions in the economy:

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10 MONEY AND PRICES IN THE LONG RUN Chapter 29 The Monetary System

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  1. 10 MONEY AND PRICES IN THE LONG RUNChapter 29The Monetary System

  2. 29.1 The Meaning of Money • Moneyis the set of assets in an economy that people regularly use to buy goods and services from other people.

  3. 29.1.1 The Functions of Money • Money has three functions in the economy: • Medium of exchange • Unit of account • Store of value

  4. 29.1.1 The Functions of Money • Medium of Exchange • A medium of exchangeis 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.

  5. 29.1.1 The Functions of Money • Unit of Account • A unit of accountis the yardstick people use to post prices and record debts. • Store of Value • A store of valueis an item that people can use to transfer purchasing power from the present to the future.

  6. 29.1.1 The Functions of Money • Liquidity • Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.

  7. 29.1.2 The Kinds of Money • Commodity moneytakes the form of a commodity with intrinsic value. • Examples: Gold, silver, cigarettes. • Fiat moneyis used as money because of government decree. • It does not have intrinsic value. • Examples: Coins, currency, check deposits.

  8. 29.1.3 Money in the U.S. Economy • Currencyis the paper bills and coins in the hands of the public. • Demand deposits活期存款are balances in bank accounts that depositors can access on demand by writing a check.

  9. 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) Figure 1 Money in the U.S. Economy in 2001 Billions of Dollars 0

  10. Appendix: MONEY STOCK MEASURES • 1. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately.

  11. Appendix: MONEY STOCK MEASURES • 2. M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. • Seasonally adjusted M2 is constructed by summing savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to seasonally adjusted M1. (http://www.federalreserve.gov/releases/h6/Current/)

  12. 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

  13. 29.2 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.

  14. 29.2 THE FEDERAL RESERVE SYSTEM • The Fed was created in 1914 after a series of bank failures in 1907 convinced Congress that the United States needed a central bankto ensure the health of the nation’s banking system.

  15. 29.2 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理事会 • 2) The Regional Federal Reserve Banks • 3) The Federal Open Market Committee

  16. Reserve Bank Residents Federal Open Market Committee (FOMC):Directs open-market operations; advises on discount rate and reserverequirements New York Chairman of the Board of Governors Board of Governors:Approves discount rates; sets reserve requirements; directs regulatory operations 6 governors of the Board Fig 26-2. The Major Players in Monetary Policy

  17. 29.2.1 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.

  18. 29.2.1 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.

  19. 29.2.1 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.

  20. 29.2.1 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.

  21. The Federal Reserve System

  22. 29.2.1 The Fed’s Organization • The Federal Reserve Banks • The New York Fed implements some of the Fed’s most important policy decisions.

  23. 29.2.1 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.

  24. 29.2.1 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).

  25. 29.2.1 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.

  26. 29.2.2 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 policyby controlling the money supply.

  27. 29.2.2 The Federal Open Market Committee • Open-Market Operations • The money supplyis 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.

  28. 29.2.2 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.

  29. 29.3 BANKS AND THE MONEY SUPPLY • Banks can influence the quantity of demand deposits in the economy and the money supply.

  30. 29.3 BANKS AND THE MONEY SUPPLY • Reservesare deposits that banks have received but have not loaned out. • In a fractional-reserve bankingsystem, banks hold a fraction of the money deposited as reserves and lend out the rest.

  31. 29.3 BANKS AND THE MONEY SUPPLY • Reserve Ratio • The reserve ratiois the fraction of deposits that banks hold as reserves.

  32. 29.3.2 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.

  33. First National Bank Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 29.3.2 Money Creation with Fractional-Reserve Banking • This T-Account shows a bank that… • accepts deposits, • keeps a portion as reserves, • and lends out the rest. • It assumes a reserve ratio of 10%.

  34. 29.3.2 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.

  35. 29.3.3 The Money Multiplier • How much money is eventually created in this economy? • The money multiplieris the amount of money the banking system generates with each dollar of reserves.

  36. First National Bank Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 29.3.3 The Money Multiplier Second National Bank Assets Liabilities Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00 Money Supply = $190.00!

  37. 29.3.3 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. • Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier.

  38. 29.3.4 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

  39. 1. Open-market Operations 2. Discount rate 3. Reserve requirements 1.Stable prices 2. Low unemployment 3. Rapid Growth in real GDP 1.Money supply 2. Interest rate 3. Commercial bank’s Reserves instruments Intermediate targets Ultimate objectives Fig29-3. While the Fed Ultimately Pursues Objectives like Stable Prices, Its short-term Operations Focus on the intermediate targetsIn determining monetary policy, the Fed directly manipulates the instruments or policy variables under its control----open-market operations, the discount rate, and reserve requirements. These help determine bank reserves, the money supply, and interest rates----the intermediate targets of monetary policy. Ultimately, monetary and fiscal policies are partners in pursuing the major objectives of rapid growth, low unemployment, and stable prices. (Samuelson,Economics,18th edition, figure26-3,p534.)

  40. 29.3.4 The Fed’s Tools of Monetary Control • Open-Market Operations • The Fed conducts open-market operationswhen 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.

  41. 29.3.4 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.

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