Ch. 8: Money, the Price Level, and Inflation

1. Ch. 8: Money, the Price Level, and Inflation • Definition of money and its functions • Economic functions of banks • Structure and function of the Federal Reserve System • Creation of money by the banking system • Demand for money, the supply of money, and the nominal interest rate • Link between quantity of money, the price level and inflation

2. Anything that is generally acceptable as a means of payment. Commodity Money gold dust, tobacco, cigarettes in POW camp Problems transactions cost; perishable; value fluctuates. Coins with precious metal Gold & silver coins Problems Coin shaving value of metal fluctuates. Greshams Law: Bad money drives out good (more later). Fiat money What is Money?

3. U.S. constitution gave Congress sole right to "coin money and regulate value thereof". Illegal for states to coin money. Bi-metallic standard initially. In the 1792 coin act, a $1 coin was quoted in terms of both silver and gold 24.75 grains of gold =$1 371.25 grains of silver = $1 i.e. a grain of gold was worth 15 times a grain of silver. MONEY IN U.S. HISTORY

4. “Bad money drives out good" Prior to 1834 1 grains of gold was worth more than 15 grains of silver. Only silver coins circulated ("silver standard"). After 1834, reverse was true (a "gold standard") The Crime of 1873: demonetization of silver After 1873, price of gold began to rise and deflation occurred in U.S. Wizard of Oz and bimetallic standard GRESHAM’S LAW

5. Medium of Exchange Generally accepted in exchange for goods and services. Without money, trade is barter. Barter requires a double coincidence of wants makes it costly. Unit of Account An agreed measure for stating the value of goods and services. Store of Value Money can be held for a time and later exchanged for goods and services. Can be poor store of value Inflation No interest 3 Functions of Money

6. Initially banks formed as “safekeeping” institutions. Gradually evolved to serve several functions: Minimize the cost of borrowing funds Minimize the cost of monitoring borrowers Link lenders with borrowers Pool risks for lenders Create liquidity HISTORY OF BANKING

7. States could not print or mint money, but privately owned banks could if licensed by the state government. Banks printed notes that were backed by gold or silver easier to trade avoided problems with weighing banks found it profitable to print more notes than they had "reserves“ (gold/silver) for and loaned out the extra notes. Fractional reserve banking was started. Fractional reserve banking poses problems if there is a bank run. HISTORY OF BANKING

8. AssetsLiabilities Reserves (gold) 100 Notes 100 Total 100 100 Banks would print notes beyond reserves and extend loans. Reserves 100 Notes 1000 Loans 900 ____ Total 1000 1000

9. With “fractional reserve banking”, the banking system “creates money” and lends it out. has only a fraction of liabilities on reserve. cannot satisfy customer’s demands if all want to withdraw deposits at once. Source of “bank panics”. News that loans are not likely to be paid back, customers will make a “run” on the bank. Droughts. Stock market crash. Effect of bank panic on economy?

10. 7 major bank panics in the U.S. in the 1800s 2 in the early 1900s. Onset of the great depression in the 1930s, another bank panic occurred. In 1934, the federal government established FDIC to help reduce spread of bank panics. Deposit insurance has reduced bank panics in the U.S. Problems with deposit insurance Incentives created for risk taking (moral hazard). The 1985 Home State experience in Ohio. The most recent financial crisis. Bank Panics and Deposit Insurance

11. Goal of any bank is to maximize wealth of its owners. To accomplish this, must consider: Attracting deposits to make loans possible. Choosing loan portfolio and balance risk versus return. Liquidity Service quality, fees, etc. Bank Objectives.

12. Risk, Return, and Liquidity. Liquid assets (low risk, low return) U.S. government Treasury bills and commercial bills 2. Investment securities longer–term U.S. government bonds and other bonds 3. Loans (higher risk, higher return) commitments of fixed amounts of money for agreed-upon periods of time Bank Objectives.

13. Established in 1913 by the Federal Reserve Act. First central bank of the United States Conducts monetary policy and regulates banks. Aims to stabilize the macroeconomy. Structure The Board of Governors The 12 regional Federal Reserve banks Federal Open Market Committee Federal Reserve System

14. Board of Governors 7 members appointed by the president and confirmed by Senate. Terms are for 14 years The president appoints one member to a four-year term as chairman. Regional Banks Each of the 12 Federal Reserve Regional Banks has a nine-person board of directors and a president. Monitors economic conditions within district and regulates banks Clearinghouse for checks and replacement of currency The Federal Reserve System

16. Federal Open Market Committee FOMC is the main policy-making group in the Federal Reserve System. 7 members of the Board of Governors President of FRB of NY 11 presidents of the other regional FRB of whom, on a rotating basis, 4 are voting members. The FOMC meets every six weeks to formulate monetary policy. The Federal Reserve System

17. Bank reserves bank deposits at the Federal Reserve + cash Monetary base currency held by the nonbank public + bank reserves. M1 currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses. M2 M1 plus time deposits, savings deposits, and money market mutual funds and other deposits. Components of the Money Supply

19. Suppose that there is $100 million of cash and no bank system. A bank now begins and $90 million of cash is deposited in the bank in exchange for checking account (demand deposit) balances. The bank’s owners invest $5 million in plant and equipment and thus have $5 million of owner’s equity. The bank’s balance sheet is now: How do banks create money?

20. How do banks create money? Note: The balance sheet requires that total assets equal total liabilities.

21. Fed sets a reserve ratio (let’s suppose it’s 25%). Implying bank must have 25% of it’s demand deposits on reserve. Reserves = cash in bank + deposits at Fed. Bank can increase demand deposits by creating new loans to customers until it no longer has any excess reserves. required reserves = rr * demanddeposits Maximum demand deposits = (1/rr) * reserves How do banks create money?

22. How do banks create money? Note: The bank system created $270 million of additional money by creating new demand deposits for borrowers (loans). This assumes that none of the new loans/demand deposits are withdrawn as cash.

23. Deposits lead to a multiplier effect on M1 as banks convert a $1 deposit into several dollars of demand deposits. To illustrate, assume rr=25% A new deposit of $100,000 is made. The bank keeps $25,000 in reserve and lends $75,000. This loan is credited to someone’s bank deposit. The person spends the deposit and another bank now has $75,000 of extra deposits. This bank keeps $18,750 on reserve and lends $56,250. How Banks Create Money

24. The process continues and keeps repeating with smaller and smaller loans at each “round.” How Banks Create Money

25. Summary of money creation process. monetary base = nonbank cash + bank reserves M1 = nonbank cash + demand dep. Maximum DD = (1/rr) * bank reserves The Fed controls the money supply through its control over the monetary base and the deposit multiplier (1/rr). How do banks create money?

26. Open market operations. The Fed buys (sells) government securities in the open market to increase (decrease) the money supply. Discount window lending. The Fed loans reserves to member banks and charges the discount rate. Reserve requirements. The Fed sets the required reserve ratio. Rarely used. Fed Tools

27. If the Fed wants to increase the amount of bank reserves buy government securities from member banks banks give up government bonds and receive deposit at the Fed or cash. More recently, Fed has purchased commercial paper from banks – new policy! By buying government securities Fed created new reserves that multiply into new loans and demand deposits (remember the deposit multiplier). If the Fed sold government securities, reserves and M1 would decrease. OPEN MARKET OPERATIONS.

28. Changes in the money supply Suppose the Fed purchases $10 m. of government securities. What is the effect on: Loans Demand deposits M1

29. The Fed lends banks reserves at the “discount rate”. The higher the discount rate, the less likely banks are to borrow reserves to increase the money supply. The federal funds rate is the interest rate that banks charge each other for a loan of reserves. The federal funds rate tracks the discount rate fairly closely. If the Fed wants to increase reserves in the system, it would lower the discount rate. DISCOUNT WINDOW LENDING.

31. If the Fed increases the reserve requirement the deposit multiplier (1/rr) falls the amount of demand deposits that banks can create for a given amount of reserves is reduced. [Note: you may ignore the “money multiplier” and the “currency drain ratio” discussed in text. Focus only on “deposit multiplier”] THE RESERVE REQUIREMENT.

32. Changes in the money supply Suppose the Fed cuts the rr to 20% What is the effect on: Loans Demand deposits M1

33. The amount of cash people choose to hold Cash in bank multiplies Cash outside bank does not. The type of deposits people make. the reserve requirement is higher on demand deposits (about 3%) than on certificates of deposit. If people switch between different types of accounts, the “average” reserve requirement and money multiplier will change. Bank holdings of excess reserves OTHER FACTORS INFLUENCING THE MONEY SUPPLY

34. Changes in the money supply: Cash held by public Suppose the public withdraws $10m. Of DD as cash. What is the effect on: Loans Demand deposits M1

35. Components of the monetary base: 1983-2013

36. M1: 1975-2013

37. Reserves vs. Excess Reserves: 1994-2013

38. The Demand for Money relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same The Demand for Money Holding The quantity of money that people plan to hold depends on four main factors: The nominal interest rate The price level Real GDP Financial innovation The Market for Money

39. The Nominal Interest Rate the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. Increase in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold. The demand for money

41. The Price Level An increase in the price level increases the quantity of nominal money people wish to hold, doesn’t change the quantity of real money demanded. Real money equals nominal money ÷ price level. 10 percent increase in P increases the quantity of nominal money demanded by 10 percent. Real GDP Increase in real GDP increases increases the quantity of real money that people plan to hold. The demand for money

42. Financial Innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold. Summary of money demand factors Nominal interest rate Price level Real GDP (income) Financial innovation The demand for money

43. Equilibrium interest rate

44. Long-Run Equilibrium In the long run, the loanable funds market determines the interest rate. Nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate. nominal interest rates on government (“risk-free”) bonds differ for different terms due to inflation expectations over different periods longer term bonds are subject to more inflation risk. The Market for Money

45. V=velocityP=price levelY=real GDPM=quantity of money The equation of exchangestates that MV = PY Expressing the equation of exchange in growth rates:  % ch in M + % ch in V = % ch in P + % ch in Y % ch in P = % ch in M + % ch in V - % ch in Y The Quantity Theory of Money

46. Quantity theory of money In the long run, velocity does not change, so Inflation rate = Money growth rate  Real GDP growth The Quantity Theory of Money

48. International evidence shows a tendency for high money growth rates to be associated with high inflation rates. Evidence for 134 countries from 1990 to 2005. The Quantity Theory of Money