Money, Prices, and the Federal Reserve

1. Money, Prices, and the Federal Reserve

2. Introduction • Money • Any asset that can be used in making purchases • Examples • Currency • Coins • Checks Chapter 10: Money, Prices, and the Federal Reserve

3. Money and Its Uses • Barter • The direct trade of goods or services for other goods or services Chapter 10: Money, Prices, and the Federal Reserve

4. Money and Its Uses • Medium of Exchange • An asset used in purchasing goods and services • Unit of Account • A basic measure of economic value • Store of Value • An asset that serves as a means of holding wealth Chapter 10: Money, Prices, and the Federal Reserve

5. Money and Its Uses • M1 • Sum of currency outstanding and balances held in checking accounts • M2 • All the assets in M1 plus some additional assets that are usable in making payments but at greater cost or inconvenience than currency or checks Chapter 10: Money, Prices, and the Federal Reserve

6. Components of M1 and M2, April 2005 (billions of dollars) M1 Currency Demand deposits Other checkable deposits Travelers’ checks M2 M1 Savings deposits Small-denomination time deposits Money market mutual funds 1,354.6 704.6 318.5 324.0 7.5 6,469.7 1,354.6 3,544.3 866.2 704.6 Chapter 10: Money, Prices, and the Federal Reserve

7. Commercial Banks and the Creation of Money • The Money Supply at Christmas • Currency = 500 • Bank reserves = 500 • Reserve-deposit ratio = 0.20 • Money supply = 500 + 500/.20 = 500 + 2,500 = 3,000 Chapter 10: Money, Prices, and the Federal Reserve

8. Commercial Banks and the Creation of Money • The Money Supply at Christmas • If Xmas shoppers withdraw 100 • Money supply = 600 + 400/.20 = 600 + 2,000 = 2,600 Chapter 10: Money, Prices, and the Federal Reserve

9. Commercial Banks and the Creation of Money • The Money Supply at Christmas • Observation • When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. • In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal. Chapter 10: Money, Prices, and the Federal Reserve

10. The Federal Reserve System • Two Main Responsibilities • Monetary policy • Oversight and regulation of financial markets Chapter 10: Money, Prices, and the Federal Reserve

11. The Federal Reserve System • The History and Structure of the Federal Reserve System • Founded by the Federal Reserve Act of 1913 • The primary mission of the Fed is to promote economic growth, low inflation, and stable financial markets. Chapter 10: Money, Prices, and the Federal Reserve

12. The Federal Reserve System • The Structure • 12 regional Federal Reserve banks • Assess economic conditions in their regions to assist in national policymaking • Provide service to the commercial banks in their districts Chapter 10: Money, Prices, and the Federal Reserve

13. The Federal Reserve System • The Structure • Board of Governors • Seven governors • Appointed by the president and confirmed by the Senate to 14 year staggered terms • Chairman of the Board of Governors • Selected by the president from the governors • Serves a four year term Chapter 10: Money, Prices, and the Federal Reserve

14. The Federal Reserve System • The Structure • Federal Open Market Committee (FOMC) • Members include: • The seven Fed governors • President of the New York Fed • Four presidents, chosen on a rotating basis, from the remaining Federal Reserve Banks • Determines monetary policy Chapter 10: Money, Prices, and the Federal Reserve

15. The Federal Reserve System • Controlling the Money Supply: Open-Market Operations • The primary function of the Fed is monetary policy. • The Fed controls the money supply by changing the supply of bank reserves. Chapter 10: Money, Prices, and the Federal Reserve

16. The Federal Reserve System • Controlling the Money Supply: Open-Market Operations • Open-market operations are the most important method of changing the supply of bank reserves. Chapter 10: Money, Prices, and the Federal Reserve

17. The Federal Reserve System • Open-Market Operations • Open-market purchases and open-market sales Chapter 10: Money, Prices, and the Federal Reserve

18. The Federal Reserve System • Open-Market Purchase • The purchase of government bonds from the public by the Fed for the purpose of increasing the supply of bank reserves and the money supply Chapter 10: Money, Prices, and the Federal Reserve

19. The Federal Reserve System • Increasing The Money Supply • The Fed purchases government bonds from the public. • The people deposit the funds they get from their sale of bonds to the Fed. • The increase in deposits increase bank reserves. Chapter 10: Money, Prices, and the Federal Reserve

20. The Federal Reserve System • Increasing The Money Supply • The increase in reserves will lead to an expansion of the money supply as banks make more loans. • Recall • The change in the money supply is a multiple of the change in reserves. Chapter 10: Money, Prices, and the Federal Reserve

21. The Federal Reserve System • Open-Market Sale • The sale by the Fed of government bonds to the public for the purpose of reducing bank reserves and the money supply Chapter 10: Money, Prices, and the Federal Reserve

22. The Federal Reserve System • Reducing The Money Supply • The Fed sells government bonds to the public. • The Fed presents the checks from the sale of the bonds to the banks for payment. Chapter 10: Money, Prices, and the Federal Reserve

23. The Federal Reserve System • Reducing The Money Supply • The bank’s reserves will fall when they clear the checks. • The money supply will fall by a multiple of the decrease in reserves. Chapter 10: Money, Prices, and the Federal Reserve

24. The Federal Reserve System • Example • Increasing the money supply by open-market operations • Currency = 1,000 shekels • Reserves = 200 • Reserve-deposit ratio = 0.2 Chapter 10: Money, Prices, and the Federal Reserve

25. The Federal Reserve System • Example • Increasing the money supply by open-market operations • Money supply = 1,000 + 200/0.2 = 2,000 shekels • Open market purchase = 100 • Reserves increase to 300 • Money supply = 1,000 + 300/0.2 = 2,500 shekels Chapter 10: Money, Prices, and the Federal Reserve

26. The Federal Reserve System • The Fed’s Role in Stabilizing Financial Markets: Banking Panics • Suppose: • Depositors lose confidence in their bank. • They attempt to withdraw their funds. • Bank may not have enough reserves (fractional) to meet the depositors demand. • The bank fails and further erodes depositor confidence which triggers additional failures. Chapter 10: Money, Prices, and the Federal Reserve

27. The Federal Reserve System • The Fed’s Role in Stabilizing Financial Markets: Banking Panics • The Fed to the rescue: • Instill confidence • Discount lending • Open Market Operations Chapter 10: Money, Prices, and the Federal Reserve

28. The Federal Reserve System • Economic Naturalist • The banking panics of 1930 - 1933 and the money supply • One-third of U.S. banks closed • Depositors withdrew their funds • Banks raised the reserve-deposit ratio Chapter 10: Money, Prices, and the Federal Reserve

29. Key U.S. MonetaryStatistics, 1929-1933 Currency Reserve-deposit Bank Money held by public ratio reserves supply December 1929 3.85 0.075 3.15 45.9 December 1930 3.79 0.082 3.31 44.1 December 1931 4.59 0.095 3.11 37.3 December 1932 4.82 0.109 3.18 34.0 December 1933 4.85 0.133 3.45 30.8 Chapter 10: Money, Prices, and the Federal Reserve

30. The Federal Reserve System • Economic Naturalist • In response to the panics of 1929-1933, deposit insurance was established in 1934. • Deposit insurance gives depositors an incentive to keep their money in the banks. • Deposit insurance reduces the incentive for depositors to pay attention to the financial strength of their bank. Chapter 10: Money, Prices, and the Federal Reserve

31. The Federal Reserve System • What Do You Think? • Why worry about the money supply? Chapter 10: Money, Prices, and the Federal Reserve

32. Money and Prices • Velocity • A measure of the speed at which money changes hands in transaction involving final goods and services Chapter 10: Money, Prices, and the Federal Reserve

33. Money and Prices • Velocity • A measure of the speed at which money changes hands in transaction involving final goods and services Chapter 10: Money, Prices, and the Federal Reserve

34. Money and Prices • Velocity in 2004 • M1 = $1,367.3 billion • M2 = $6,428.4 billion • Nominal GDP = $11,734.3 billion Chapter 10: Money, Prices, and the Federal Reserve

35. Money and Prices • Money and Inflation in the Long Run • Recall Chapter 10: Money, Prices, and the Federal Reserve

36. Money and Prices • Money and Inflation in the Long Run • Quantity equation • M x V = P x Y • Assume V & Y are constant over the time period Chapter 10: Money, Prices, and the Federal Reserve

37. Money and Prices • Money and Inflation in the Long Run • If the Fed increases M by 10%, then prices must increase by 10%. • High rates of money growth are associated with high rates of inflation (too much money chasing too few goods). Chapter 10: Money, Prices, and the Federal Reserve

38. Money and Prices • What Do You Think? • If high rates of money growth lead to inflation, why do countries allow their money supplies to rise quickly? Chapter 10: Money, Prices, and the Federal Reserve

39. End of Chapter