Transcript The Money Supply and the Federal Reserve System

The Money Supply and
the Federal Reserve System
1
An Overview of Money
• Money is anything that is
generally accepted as a
medium of exchange.
• Money is not income, and money is not
wealth. Money is:
• a means of payment,
• a store of value, and
• a unit of account.
2
What is Money?

Barter is the direct exchange of goods
and services for other goods and
services.

A barter system requires a double
coincidence of wants for trade to take
place. Money eliminates this problem.

As a medium of exchange, or means
of payment, money is generally
accepted by buyers and sellers as
payment for goods and services.
3
What is Money?
 As
a store of value,
money serves as an
asset that can be used
to transport purchasing
power from one time
period to another.
4
What is Money?
 As a unit of account, money
is a standard that provides a
consistent way of quoting
prices.
5
What is Money?
 Money is easily portable,
and easily exchanged for
goods at all times.
 The liquidity property of
money makes money a
good medium of exchange
as well as a store of value.
6
Commodity and Fiat Monies
Commodity monies are
items used as money that
also have intrinsic value in
some other use. Gold is
one form of commodity
money.
 Fiat, or token, money is
money that is intrinsically
worthless.

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Commodity and Fiat Monies
Legal tender is money that a
government has required to be
accepted in settlement of
debts.
 Currency debasement is the
decrease in the value of money
that occurs when its supply is
increased rapidly.

8
Measuring the Supply of
Money in the United States
M1, or transactions money is
money that can be directly used for
transactions.
M1  currency held outside
banks + demand deposits +
traveler’s checks + other checkable
deposits
 M1 is a stock measure—it is
measured at a point in time—on a
specific day.

9
Measuring the Supply of
Money in the United States

M2, or broad money, includes
near monies, or close substitutes
for transactions money.
M2  M1 + savings accounts +
money market accounts + other near
monies

The main advantage of looking at
M2 instead of M1 is that M2 is
sometimes more stable.
10
The Private Banking System

Financial
intermediaries are
banks and other
financial institutions
that act as a link
between those who
have money to lend
and those who want
to borrow money.
11
How Banks Create Money
 A Historical Perspective: Goldsmiths



Goldsmiths functioned as warehouses
where people stored gold for safekeeping.
Upon receiving the gold, a goldsmith would
issue a receipt to the depositor. After a
time, these receipts themselves began to be
traded for goods, and were backed 100
percent by gold.
Then, Goldsmiths realized that they could
lend out some of this gold without any fear
of running out. Now there were more claims
than there were ounces of gold.
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How Banks Create Money
A run on a goldsmith (or a
modern-day bank) occurs when
many people present their
claims at the same time.
13
The Modern Banking System



A brief review of accounting:
Assets – liabilities  Net Worth, or
Assets  Liabilities + Net Worth
A bank’s most important assets are its loans.
Other assets include cash on hand (or vault cash)
and deposits with the Fed.
A bank’s liabilities are its debts—what it owes.
Deposits are debts owed to the bank’s
depositors.
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The Modern Banking System
• The Federal Reserve System (the Fed)
is the central bank of the United States.
15
The Modern Banking System
 Reserves
are the deposits that a
bank has at the Federal Reserve
bank plus its cash on hand.
 The required reserve ratio is the
percentage of its total deposits that a
bank must keep as reserves at the
Federal Reserve.
16
T-Account for a Typical Bank
The balance sheet of a bank must always
balance, so that the sum of assets
(reserves and loans) equals the sum of
liabilities (deposits and net worth).
T-Account for a Typical Bank (millions of
dollars)
ASSETS
LIABILITIES
Reserves
20
100
Deposits
Loans
90
10
Net worth
110
110
Total
Total
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The Creation of Money

Banks usually make loans up to the point
where they can no longer do so because
of the reserve requirement restriction (or
up to the point where their excess
reserves are zero).
excess reserves  actual reserves  required reserves
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The Creation of Money
 When
someone deposits $100 in a bank, and
the bank deposits the $100 with the central
bank, the bank has $100 in total reserves.
Balance Sheets of a Bank in a Single-Bank Economy
In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.
Panel 1
ASSETS
LIABILITIES
Reserves 0
0 Deposits
19
Panel 2
ASSETS
LIABILITIES
Reserves 100100 Deposits
Panel 3
ASSETS
LIABILITIES
Reserves 500 Deposits
100
Loans 400
The Creation of Money
 If
the required reserve ratio is 20%, the bank has
excess reserves of $80. With $80 of excess
reserves, the bank can have up to $400 of
additional deposits. The $100 in reserves plus
$400 in loans equal $500 in deposits.
Balance Sheets of a Bank in a Single-Bank Economy
In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made
loans of $400.
Panel 1
ASSETS
LIABILITIE
S
Reserves 0 0 Deposits
Panel 2
ASSETS
LIABILITIE
S
Reserves
100
100
Deposits
Panel 3
ASSETS
LIABILITIE
S
Reserves 500 Deposits
100
20
Loans 400
C H A P T E R 10: The Money Supply and the Federal Reserve System
The Creation of Money
The Creation of Money When There Are Many Banks
Panel 1
ASSETS
LIABILITIES
Panel 2
ASSETS
LIABILITIES
Panel 3
ASSETS
LIABILITIES
Reserves 100
100 Deposits
Reserves 100
Loans 80
180 Deposits
Reserves 20
Loans 80
100 Deposits
Reserves 80
80 Deposits
Reserves 80
Loans 64
144 Deposits
Reserves 16
Loans 64
80 Deposits
Reserves 64
64 Deposits
Reserves 64
115.20 Deposits
Reserves 12.80 64 Deposits
© 2004 Prentice Hall Business Publishing
Summary:
Bank 1
Bank 2
Bank 3
Bank 4
.
.
.
Total
Deposits
100
80
64
51.20
.
.
.
500.00
Principles of Economics, 7/e
Karl Case, Ray Fair
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The Money Multiplier
Summary:
Bank 1
Bank 2
Bank 3
Bank 4
.
.
.
Total
Deposits
100
80
64
51.20
.
.
.
500.00

The money multiplier is the multiple
by which deposits can increase for
every dollar increase in reserves.
1
Money multiplier =
Required reserve ratio
• In the example above, the required reserve ratio
is 20%. Each dollar increase in reserves could
cause an increase in deposits of $5 when there is
no leakage out of the system. An additional $100
of reserves result in additional deposits of $500.
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The Federal Reserve System
23
The Federal Reserve System
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The Federal Reserve System


The Federal Open Market
Committee (FOMC) sets
goals regarding the money
supply and interest rates and
directs the operations of the
Open Market Desk in New
York.
The Open Market Desk is an
office in the New York Federal
Reserve Bank from which
government securities are
bought and sold by the Fed.
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Functions of the Federal
Reserve
The Fed performs important functions
for banks including:
 Clearing interbank payments.
 Regulating the banking system.
 Assisting banks in a difficult financial
position.
 Managing exchange rates and the
nation’s foreign exchange reserves.
 Control of mergers between banks.
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Functions of the Federal
Reserve
The Fed performs important
functions for banks including:
Examination of banks to ensure
that they are financially sound.
Setting of reserve requirements for
all financial institutions.
Lender of last resort: The Fed
provides funds to troubled banks
that cannot find any other
sources of funds.
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The Federal Reserve Balance
Sheet
Assets and Liabilities of the Federal Reserve System, June 30, 2003
(millions of dollars)
ASSETS
Gold
LIABILITIES
$ 11,045
Loans to banks
36,538
U.S. Treasury
securities
550,31
4
$593,03
1
Deposits:
20,359
6,219
All other assets
Total
Federal Reserve notes (outstanding)
46,268
24,556
$ 644,16
5
$644,16
5
Source: Federal Reserve Bulletin, August 2003, Table 1.18.
Bank reserves (from depository
institutions)
U.S. Treasury
All other liabilities and net worth
Total
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The Federal Reserve Balance
Sheet



Although it is unrelated to the money
supply, the Fed’s gold counts as an
asset on its balance sheet.
The largest of the Fed’s assets, by
far, consists of government securities
purchased over the years.
A dollar bill is a liability, or IOU, of
the Fed.
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How the Federal Reserve
Controls the Money Supply

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Three tools are available to the Fed for
changing the money supply:
1. changing the required reserve ratio;
2. changing the discount rate; and
3. engaging in open market operations.
The Required Reserve Ratio
 The required reserve ratio
establishes a link between the
reserves of the commercial banks
and the deposits (money) that
commercial banks are allowed to
create.
 If the Fed wants to increase the
money supply, the Fed can decrease
the required reserve ratio, which
allows the bank to create more
deposits by making loans.
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The Required Reserve Ratio
A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases
the Supply of Money (All Figures in Billions of Dollars)
PANEL 1: REQUIRED RESERVE RATIO = 20%
Federal Reserve
Assets
Government
Commercial Banks
Liabilities
$200
securities
Assets
$100 Reserves
Reserves
$100
$100 Currency
Loans
$400
Liabilities
$500 Deposits
Note: Money supply (M1) = Currency + Deposits = $600.
PANEL 2: REQUIRED RESERVE RATIO = 12.5%
Federal Reserve
Assets
Government
securities
Liabilities
$200
Commercial Banks
Assets
Liabilities
$100 Reserves
Reserves
$100
$800 Deposits
$100 Currency
Loans
(+ $300)
$700
(+ $300)
Note: Money supply (M1) = Currency + Deposits = $900.
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The Discount Rate


The discount rate is the interest rate that banks
pay to the Fed to borrow from it.
Bank borrowing from the Fed leads to an
increase in the money supply. The higher the
discount rate, the higher the cost of borrowing,
and the less borrowing banks will want to do.
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The Discount Rate
The Effect On the Money Supply of Commercial Bank Borrowing from the Fed
(All Figures in Billions of Dollars)
PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED
Federal Reserve
Assets
Liabilities
Securities
$160
Commercial Banks
Assets
Liabilities
$80 Reserves
Reserves
$80 Currency
Loans
$80
$400 Deposits
$320
Note: Money supply (M1) = Currency + Deposits = $480.
PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED
Federal Reserve
Assets
Liabilities
Securities
Loans
Commercial Banks
Assets
Liabilities
$160
$100 Reserves
(+ $20)
Reserves
(+ $20)
$100
$20
$80 Currency
Loans
(+ $100)
$420
Note: Money supply (M1) = Currency + Deposits = $580.
$500 Deposits
(+ $300)
$20 Amount owed
to Fed (+ $20)
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The Discount Rate
 Moral suasion is the pressure that was
exerted in the past by the Fed on member
banks to discourage them from borrowing
heavily.
 On January 9, 2003, the Fed announced a
new procedure that sets the discount rate
above the rate that banks pay to borrow in
the private market. It is thus clear that the
Fed is not using the discount rate as a tool
to try to change the money supply on a
regular basis.
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Open Market Operations


Open market operations is the
purchase and sale by the Fed of
government securities in the open
market; a tool used to expand or
contract the amount of reserves in the
system and thus the money supply.
Open market operations is by far the
most significant tool of the Fed for
controlling the supply of money.
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C H A P T E R 10: The Money Supply and the Federal Reserve System
The Mechanics of
Open Market Operations
Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the
Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars)
PANEL 1
Federal Reserve
Commercial Banks
Assets
Securities $100
Liabilities
Assets
$20 Reserves
Reserves
$20
$80 Currency
Loans
$80
Note: Money supply (M1) = Currency + Deposits = $180.
Liabilities
$100 Deposits
Jane Q. Public
Assets
Deposits
$5
Liabilities
$0 Debts
$5 Net Worth
$80 Currency
PANEL 2
Federal Reserve
Assets
Securities
$95
( $5)
Liabilities
$15 Reserves
( $5)
$80 Currency
Commercial Banks
Assets
Reserves
( $5)
Loans
$15
Liabilities
$95 Deposits
( $5)
$80
Jane Q. Public
Assets
Deposits
( $5)
Securities
(+ $5)
$0
Liabilities
$0 Debts
$5
$5
Net Worth
Note: Money supply (M1) = Currency + Deposits = $175.
PANEL 3
Federal Reserve
Assets
Liabilities
Securities
$95 $15 Reserves
( $5)
( $5)
$80 Currency
Commercial Banks
Assets
Liabilities
Reserves
$15
$75 Deposits
( $5)
( $25)
Loans
$60
( $20)
Note: Money supply (M1) = Currency + Deposits = $155.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Assets
Deposits
( $5)
Securities
(+ $5)
Jane Q. Public
Liabilities
$0 $0 Debts
$5
$5
Karl Case, Ray Fair
Net Worth
37 of 42
Open Market Operations

An open market purchase of
securities by the Fed results in an
increase in reserves and an
increase in the supply of money by
an amount equal to the money
multiplier times the change in
reserves.
38
Open Market Operations

An open market sale of securities by
the Fed results in a decrease in
reserves and a decrease in the
supply of money by an amount equal
to the money multiplier times the
change in reserves.
39
Open Market Operations

Open market operations are the Fed’s
preferred means of controlling the money
supply because:

they can be used with some precision,

are extremely flexible, and

are fairly predictable.
40
The Supply Curve for Money

41
Through open market
operations, the Fed
can have the money
supply be whatever
value it wants.
Review Terms and Concepts
barter
M1, or transactions money
commodity monies
M2, or broad money
currency debasement
discount rate
medium of exchange, or means of
payment
excess reserves
money multiplier
Federal Open Market Committee
(FOMC)
near monies
Federal Reserve System (the Fed)
open market operations
fiat, or token, money
required reserve ratio
financial intermediaries
reserves
legal tender
run on a bank
lender of last resort
store of value
liquidity property of money
unit of account
Open Market Desk
42