Money and Prices in the Long Run

Why is money so useful?

It facilitates exchange in our economy

What would we be forced to do without money?

Barter

What does money represent?

Purchasing power

What can the quantity of money in circulation influence?

The level of economic activity

What can too much money lead to?

Inflation

What can too little money lead to?

Deflation

What definition of money do economists use?

Money is any asset that functions as a medium of exchange, a unit of account, and a store of value

What is a medium of exchange?

An item that buyers can use to purchase goods and services

Under what condition can money be used as a medium of exchange?

Sellers have to be confident that they can use the money they receive to pay for the things they wish to purchase

The usefulness of money as a medium of exchange explains what?

Why people are willing to hold onto it even though it earns no interest

What compensates for the lack of interest payments received from money?

The ability to quickly and easily complete a transaction

What is a unit of account?

A yardstick used to establish the values of different goods and services

When is using money as a unit of account is helpful?

When discussing salary, housing prices, and clothing

How is the use of money as a medium of exchange closely linked to its use as a unit of account?

Because money is used to buy and sell things, it makes sense to express prices in money terms

What is a store of value?

An item that people can use to transfer purchasing power from the present into the future

A seller that accepts dollar bills today in exchange for a good or service can do what?

Hold onto the bills for a while before becoming a buyer

How is paper currency different from stocks or bonds?

It pays no interest and offers no opportunities for appreciation in value

What is the meaning of wealth that economists use?

Wealth is all of the different stores of value in an economy

What is liquidity?

The ease with which an asset can be converted into the economy's medium of exchange

What is the most liquid asset?

Currency

What kinds of assets are also highly liquid?

Deposits held in checking accounts, most stocks and bonds, and shares of mutual funds

What assets are less liquid?

Real estate and collectable antiques

What is commodity money?

Money that has intrinsic value

What are some examples of commodity money?

Precious metals and cigarettes

What is fiat money?

Money whose value is not intrinsic and is instead established by government decree

What is included in currency?

Paper bills and coins

What kind of wealth is nearly as good as currency?

The wealth represented by your checking account

What other accounts are equivalent to checking accounts?

Savings accounts and mutual fund accounts

What are the most widely used measures of the stock of money in the economy?

M1 and M2

What is included in M1?

Currency, savings deposits, checking deposits, other checkable deposits

What is included in M2?

Everything in M1 as well as small denomination time deposits and retail money funds

Why are credit cards not included in either M1 or M2?

Credit cards are merely a way of putting off a payment

How do credit cards help reduce the economy's need for money?

Credit card holders can use them to pay many of their bills at one time, making them likely to hold less currency

What determines the amount of money in the US economy?

The interaction between the public, commercial banks, and the Federal Reserve System

What is the Federal Reserve System?

The central bank of the United States

What is a central bank?

An institution created to oversee the banking system and regulate the supply of money

When was the Fed created?

1913

What does the Fed consist of?

Twelve regional banks and the Federal Reserve Board

Who runs the Fed?

A board of governors that consists of seven members that are appointed by the President and confirmed by the Senate

How long are the Fed's governors' terms?

14 years, in order to insulate them from political pressures

What are the twelve regional banks responsible for?

Overseeing commercial banks in their respective regions, facilitating transactions by clearing checks, and making loans to banks

What happens when a member bank is unable to obtain funds from other sources?

The Federal Reserve banks act as a lender of last resort to maintain the stability of the overall banking system

What is the money supply?

The quantity of money in the economy

What is the responsibility of the Federal Open Market Committee (FOMC)?

Controlling the money supply

Who makes up the FOMC?

The seven governors of the Fed plus five regional bank presidents

How are the regional bank presidents chosen?

The president of the New York Fed is always a member, but the other four spots rotate between the other banks

What do FOMC members do?

They meet every six weeks in Washington, DC to determine if any changes in monetary policy are necessary

How does the FOMC adjust the money supply?

It adjusts administered rates

What are administered rates?

Interest rates that the Fed sets to affect the Fed funds rate

What does the Fed do if it wants to stimulate a recessionary economy?

It lowers the discount rate and the interest rate on reserves

How does a lower discount/interest rate stimulate the economy?

It encourages banks to loan money to customers and businesses, increasing the amount of currency and deposits in the hands of the public

What does the Fed do if it wants to reduce inflationary pressures?

It raises administered rates to encourage banks to hold more money in their reserve

What is ample reserve policy?

The use of the Fed's administered rates to affect the Fed funds rate

What is limited reserve policy?

The use of the required reserve ratio, the discount rate, and open market operations to manage the money supply

What are open market operations?

The buying and selling of government securities to influence the money supply

In countries that follow a limited reserve policy, how does the central bank increase the money supply?

It purchases government bonds from banks or the public, increasing the amount of currency and deposits in the hands of the public

What does a bank's assets consist of?

The cash it holds in its vault

What does a bank's liabilities consist of?

The deposits that depositors can withdraw at any time

What are reserves?

The fraction of deposit liabilities that banks hold to meet depositor withdrawals

How can banks earn a profit?

By lending out a portion of the deposits they hold to borrowers

How do banks create money while not actually creating more wealth?

While borrowers gain assets from banks, they also gain a debt they have to repay

How do banks affect the economy?

They make the economy more liquid, but they don't increase the total amount of wealth in the economy

How can the process of money creation continue beyond the initial loans made by a bank?

Borrows may deposit loans in another account until they make a purchase. Once that happens, the seller can deposit the funds they receive in their bank account

What will eventually happen to the funds that a bank loans?

They will return to the bank as additional deposits

What is the money multiplier?

The amount of money the banking sector creates from each dollar of reserves

What is the money multiplier in terms of the reserve ratio?

$1/R, where R is the reserve ratio

How does the public's behavior affect the money supply?

Through decisions about how much money to hold as bank deposits and how much to hold as currency

What is the monetary base (aka high-powered money)?

The amount of currency plus reserves

If the Fed provides M dollars of currency and the public chooses to hold C dollars as currency, how much does the banking sector hold in reserves?

M-C

If banks hold a fraction (R) of each dollar of deposits as reserves, how many dollars worth of deposits are there in terms of M, C, and R?

(M-C)/R

What does the money supply equal in terms of M, C, and R?

C+(M-C)/R

In a limited reserve system, how can a central bank influence the money supply?

Setting reserve requirements for commercial banks

What percent did the FOMC set the reserve requirement to in 2020?

Zero percent

Why did the FOMC set the reserve requirement to 0%?

The US had transitioned to an ample reserve system

What has the US been unable to do since transitioning to an ample reserve system?

Calculate a money multiplier for lending

What is the discount rate?

The interest rate that the central bank charges on loans that it makes to banks

What is the federal funds rate?

The rate charged by banks when they lend reserves to other banks

What affect does raising the discount rate have?

It reduces the quantity of borrowed reserves and therefore the money supply as well

What is a problem that can arise in a system based on fractional reserves?

The public suddenly deciding that it wants to hold substantially more currency

Why is a sudden increase in the demand for currency a problem for banks?

The reserves banks hold are only a fraction of their liabilities so they will not be able to pay all their depositors

What is a bank run?

A rush of withdrawals

What causes bank runs?

Depositors' fear that they may not be able to withdraw their deposits

When is a bank solvent?

When its assets exceed its liabilities

Even solvent banks will have to shut their doors during a bank run until what happens?

Loans are repaid or the bank can borrow additional funds or sell assets

What does the Fed do when a solvent bank experiences a spike in demand?

It steps in as the lender of last resort

How frequent are bank runs today compared to the past?

They don't happen as often

How much has CPI increased from 1960 to 2019?

By a factor of 8.6

When did CPI decline?

During the Great Depression and during the 2008 financial crisis

What change is inflation tied to?

Changes in the value of money

What happens to the value of money when the economy's price level rises?

The value of money relative to goods and services declines

If P is the price level, what is the quantity of goods and services that can be bought with $1?

1/P

If P is the price of goods and services measured in money, what is 1/P the value of?

Money in terms of goods and services

How is the value of money determined in the long run?

By the interaction of supply and demand

What happens when the Federal Reserve uses a higher interest rate on reserves?

Banks are encouraged to hold more money and the supply of money contracts

What happens when the Federal Reserve decreases the interest on reserves?

The supply of money expands

What does the demand for money depend on?

How much of their wealth people wish to hold as money, instead of in the form of less liquid assets

Why do people choose to hold money over other assets?

The usefulness of money as a medium of exchange

What will reduce the need to use money?

The greater use of digital payments and contactless payment

What are the determinants of how much money people demand?

The volume of transactions they engage in and the prices at which these transactions take place

What would happen to the demand for money if all prices doubled?

Demand would also double