Chapter 31 - Money and the monetary system. In this chapter you will learn: What the main functions of money are and what makes something a good choice for money? How to explain the concept of fractionalreserve banking and the money multiplier? What role the central bank plays and what the Federal Reserve’s (Fed) dual mandate is?...
Chapter 31 Money and the Monetary System © 2014 by McGraw-Hill Education What will you learn in this chapter? • What the main functions of money are and what makes something a good choice for money • How to explain the concept of fractionalreserve banking and the money multiplier • What role the central bank plays and what the Federal Reserve’s (Fed) dual mandate is • How the Fed conducts monetary policy • How monetary policy affects interest rates, the money supply, and the broader economy © 2014 by McGraw-Hill Education What is money? Functions of money • Money is the set of all assets that are regularly used to directly purchase goods and services • Money serves three main functions: Store of value: Money represents a certain amount of purchasing power Medium of exchange: Money can be used to purchase goods and services – A barter system is where people directly offer a good or service for another good or service Unit of account: Money provides a standard unit of comparison © 2014 by McGraw-Hill Education What makes for good money? • There are two basic considerations that make certain money better than others • Stability of value: – Early versions of money generally took the form of a physical material that was durable and had intrinsic value – Money does not need intrinsic value to maintain stability • Convenience: – Technology has allowed for the development of more convenient forms of money • For example, paper money is more convenient than gold coins © 2014 by McGraw-Hill Education Commodity-backed money versus fiat money • Any form of money that can be legally exchanged into a fixed amount of an underlying commodity is commodity-backed money – The most common underlying commodity is gold • Money created by rule, without any commodity backing it, is fiat money – U.S currency is backed only by the trust that the government will keep the value of money relatively constant © 2014 by McGraw-Hill Education Banks and the money-creation process • Paper money made it possible for banks to create money through a process called fractional-reserve banking • The primary way that banks earn money is through lending a fraction of deposited funds and collecting interest on those loans – Demand deposits are funds held in bank accounts that can be withdrawn by depositors at any time, without advance notice © 2014 by McGraw-Hill Education Banks and the money-creation process • Reserves refers to the money that banks keep on hand • The reserve ratio is the ratio of the total amount of demand deposits at the bank to the amount kept as cash reserves – Required reserves is the amount that a bank is legally required to keep on hand – Excess reserves is any additional amount that a bank chooses to keep beyond the required reserves © 2014 by McGraw-Hill Education Banks and the money-creation process The money creation process occurs through banks repeatedly accepting deposits and lending out a fraction of the deposits Original deposit of 1,000 gold coins 100 gold coins held on reserve (10% of original deposit) 900 gold coins loaned out (90% of original deposit) One gold coin Deposit of 900 more gold coins Total deposits = 1,000 gold coins + 900 gold coins = 1,900 gold coins © 2014 by McGraw-Hill Education Banks and the money-creation process A simple way to account for a bank’s transactions is by using T-account formatting to record changes in banks assets and liabilities Original deposit Assets Cash: Liabilities $1,000 Deposit: $1,000 Bank makes its first loan Assets Loan: Required reserves: $900 Liabilities Deposit: $1,000 $100 The loan is deposited in the bank The bank loans out 90% of its new deposits Assets Assets Loan: $900 New cash deposit: $900 Required reserves: $100 Liabilities Deposit: $1,900 Liabilities Loans: $1,710 Deposit: $1,900 Required reserves: $190 The above process increases money by $900 © 2014 by McGraw-Hill Education Active Learning: Money creation A bank accepts a $1,000 deposit If the bank has a reserve ratio of 20% and loans out the rest, find the change in assets and liabilities Assets Loans: Required reserves $2,000 Liabilities Deposit: $2,500 $500 © 2014 by McGraw-Hill Education 10 Banks and the money-creation process • The money creation process continues with repeated cycles of lending and depositing of funds • The money multiplier is the ratio of money created by the lending activities of the banking system to the money created by the central bank: Money multiplier = • In a fractional-reserve banking system, banks keep less than 100% of their deposits on reserves © 2014 by McGraw-Hill Education 11 Active Learning: The money multiplier Use the money multiplier equation to fill in the blanks in the following table Situation Reserve ratio A 10% B 5% C © 2014 by McGraw-Hill Education Money Multiplier 12 Measuring money • The money supply is the amount of money available in the economy – The money supply is managed by the Fed • The Fed classifies different types of money by their liquidity – The monetary base includes cash and bank reserves, sometime referred to as hard money – M1 includes cash plus checking account balances – M2 includes M1 plus savings accounts and other financial instruments © 2014 by McGraw-Hill Education 13 Measuring money Each measure provides a distinct understanding of the financial system Hard money, M1, and M2 over time • M1 indicates liquidity • M2 indicates savings • M2 is a measure of the money multiplier when compared to the monetary base Hard money Trillions of U.S dollars 10 M2 M1 1984 1989 1994 1999 2004 2009 © 2014 by McGraw-Hill Education 14 Managing the money supply • The central bank is the institution responsible for managing the nation’s money supply and coordinating the banking system • In the U.S., the central bank is the Federal Reserve, which has been mandated by Congress to conduct monetary policy to perform two essential functions: Manage the money supply Act as a lender of last resort • Monetary policy refers to the actions made by the central bank to manage the money supply © 2014 by McGraw-Hill Education 15 Managing the money supply The Federal Reserve System has a seven-member Board of Governors and twelve regional banks that collectively act as the central bank of the U.S Minneapolis Boston Chicago San Francisco Cleveland Philadelphia Kansas St City Louis Dallas NewYork Board of Governors, Richmond Washington D.C Atlanta © 2014 by McGraw-Hill Education 16 Managing the money supply • In addition, five of the twelve regional bank presidents serve on the Federal Open Market Committee, or FOMC – Carries full responsibility for setting the overall direction of monetary policy and guiding the money supply • The Fed has a twin or dual mandate: – Ensuring price stability: Enacting monetary policy that meets the needs of the economy while keeping prices constant over time – Maintaining full employment: Enacting monetary policy that keeps the economy strong and stable © 2014 by McGraw-Hill Education 17 Tools of monetary policy • The Fed achieves these mandates by managing the money supply through three main tools The reserve requirement is the amount of money banks must hold in reserve The discount window is the lending facility that allows banks to borrow reserves from the Fed • The discount rate is the interest rate charged by the Fed for loans through the discount window Open-market operations are sales or purchases of government bonds by the Fed to or from banks on the open market © 2014 by McGraw-Hill Education 18 Tools of monetary policy • These transactions directly impact the money supply – Contractionary monetary policy is when money supply is decreased to lower aggregate demand – Expansionary monetary policy is when money supply is increased to raise aggregate demand • Open market operations also affect the inter-bank lending market, the federal funds market – The federal funds rate is the interest rate at which banks lend reserves to one another • The Fed affects the federal funds rate through changes in the supply of reserves by conducting contractionary and expansionary monetary policy © 2014 by McGraw-Hill Education 19 The economic effects of monetary policy • Monetary policy primarily influences the economy through changes in the interest rate • Changes in the interest rate, in turn, affect the appeal of borrowing and lending, which can have significant impacts on the economy The liquidity-preference model • The liquidity-preference model refers to the idea that the quantity of money people want to hold is a function of the interest rate Interest rate, r Monetary supply r* Monetary demand Q* Quantity of money © 2014 by McGraw-Hill Education – This means the money demand curve slopes downward – The Fed sets the money supply, which means the money supply curve is set by monetary policy 20 The economic effects of monetary policy The liquidity-preference model explains how the Fed’s actions can change interest rates Shifts in the money supply curve Interest rate, r MSc MS* MSe rc r* re MD Qe Q* Quantity of money © 2014 by McGraw-Hill Education Qc • Expansionary monetary policy results in a higher quantity of money and lower interest rates • Contractionary monetary policy results in a lower quantity of money and higher interest rates 21 Active Learning: The money supply For each of the following situations, indicate the effect (increase or decrease) on the money supply and interest rate Change in money supply Situation Change in interest rate The Federal Reserve conducts open-market bond purchases The Federal Reserve sells government bonds on the open market © 2014 by McGraw-Hill Education 22 Expansionary monetary policy Expansionary monetary policy Expansionary monetary policy and the AD/AS model Price level Interest rate, r LRAS MS1 MS2 SRAS P2 P1 r1 AD2 r2 Money demand AD1 Q1 Q2 Quantity of money Y1 Y2 Real GDP • During a recession, expansionary monetary policy decreases the interest rate • Cheaper to borrow and less rewarding to save money • The aggregate demand curve shifts out ã Price and output increase â 2014 by McGraw-Hill Education 23 Contractionary monetary policy Contractionary monetary policy Contractionary monetary policy and the AD/AS model Interest rate, r Price level LRAS MS SRAS MS P1 P2 r2 AD1 r1 AD2 MD Q2 Q1 Quantity of money • During overheating, contractionary monetary policy increases the interest rate • More expensive to borrow and encourages saving © 2014 by McGraw-Hill Education Y2 Y1 Real GDP • The aggregate demand curve shifts in • Prices and output decrease 24 The economic effects of monetary policy Analyzing the use of monetary policy shows how policy can work in ideal cases, but it is rare for the world to work so cleanly Challenges Advantages • The Fed faces time lags and imperfect information • The Fed does not have to wait for politicians to come to a policy consensus • The Fed is made up of prominent economic policy-makers – A few months can pass before the Fed’s actions make their impact – Mistiming of monetary policy could make economic conditions worse – It is their job to make sure they fully understand the nuances of the overall economy © 2014 by McGraw-Hill Education 25 Two interconnected markets • One concern is how the lending market is affected during times of expansionary monetary policy • That is, it may be that extra borrowing causes a shortage of loanable funds, as the demand from borrowers increases and the supply from savers decreases • This leads to two very different models of the way the world works: The Federal Reserve determines the interest rate by managing the supply and demand for money The market as a whole determines the interest rate by the interaction of savers and borrowers © 2014 by McGraw-Hill Education 26 Two interconnected markets These two models are connected by the dynamics of the economy Market for loanable funds Liquidity-preference model Interest rate Interest rate MS MS Savings Savings r1 r1 r2 r2 MD Q1 Q2 Quantity of dollars • When the Fed acts to lower interest rates, it spurs borrowing and increases output in the economy © 2014 by McGraw-Hill Education Investment Q1 Q2 Quantity of dollars • Some of this increase in output is saved • Shifts the supply of loanable funds outward to equalize interest rates between models 27 Summary • The three main functions of money are a store of value, a medium of exchange, and a unit of account • Money needs to have stability of value to be convenient • Banks create money by lending through the fractional reserve banking • The money multiplier is the ratio of money created by the lending activities to the money created by the central bank © 2014 by McGraw-Hill Education 28 Summary • The Fed classifies different types of money by their liquidity – M1 includes hard money plus checkable deposits – M2 includes M1 plus money in savings accounts and CDs • The central bank maintains the money supply and coordinates the banking system • The Federal Reserve has a dual mandate: – Ensure price stability – Maintain full employment © 2014 by McGraw-Hill Education 29 Summary • Monetary policy includes changing the reserve requirement, lending through the discount window, and engaging in open-market operations • The liquidity-preference model explains that the demand for money is a function of the interest rate • The Fed may want to engage in expansionary or contractionary monetary policy depending on the economic circumstances © 2014 by McGraw-Hill Education 30 10 ... Measuring money • The money supply is the amount of money available in the economy – The money supply is managed by the Fed • The Fed classifies different types of money by their liquidity – The monetary. .. McGraw-Hill Education Banks and the money- creation process • Reserves refers to the money that banks keep on hand • The reserve ratio is the ratio of the total amount of demand deposits at the. .. means the money demand curve slopes downward – The Fed sets the money supply, which means the money supply curve is set by monetary policy 20 The economic effects of monetary policy The liquidity-preference