Eco 103 Chp. 10 Notes

Money

Money

any asset that can be used in making purchases

• Ex. currency, coin, checking account balance

  • Shares of stock is not, for example, money

anything that is generally accepted in payment for goods or services or in the repayment of debts

• Any asset that can be used in making purchases

• Economists often distinguish money from:

1. Wealth- total property that stores values; includes not only money but aslo other assets like bonds, stocks, land, and houses

   1. Shares of stock is part of wealth, but not money

2. Income- flow of earnings per unit of time denominated in dollars

Three principal uses of money

1. Medium of exchange- money is used to purchase goods and services

   1. Without money, all economic transactions would have to be in the form of barter (the direct trade of goods or services for other goods or services)

      1. Barter is inefficient because it requires that each party to a trade has something the other part wants

2. Unit of account- money is the basic yardstick for measuring economic value

   1. Expressing economic values in a common unit of account allows for easy comparisons

M1

money is the sum of currency outstanding and balances held in checking accounts

M2

money is the sum of currency outstanding and balances held in checking accounts plus some additional assets that are usable in making payments but at greeted cost or inconvenience than currency or checks

Bank reserves

cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments

• Are held by banks in their vaults, rather than circulated among the public, and thus are not counted as part of the money supply

100% Reserve Banking

a situation in which banks’ reserves equal 100% of their deposits

Reserve-deposit ratio

bank reserves/deposits

Fractional-reserve banking

a banking system in which bank reserves are less than deposits so that the reserve-deposit ratio is less than 100%

Desired reserve-deposit ratio

bank reserves / bank deposits

• Depositors will expand through additional rounds of lending as long as the ratio of bank reserves to bank deposits exceeds the reserve-deposit ratio desired by banks

  • When the actual ratio of bank reserves to deposits equals the desired reserve-deposit ration, the expansion stops

Bank deposits

bank reserves / desired reserve-deposit ratio

Money supply

currency in the hands of the public + bank deposits

• Also equals currency held by public + (bank reserves) / (desired reserve-deposit ratio)

Federal Reserve System

the central bank of the US

• Two main responsibilities:

1. Monetary policy- determines how much money circulates in the economy

   1. Changes in the money supply can affect interest rates, inflation, unemployment, and exchange rates

   2. The Fed in particular, does not control the money supply directly

      1. However, they can control the money supply indirectly by changing the supply of reserves held by commercial banks

2. Oversight and regulation of financial markets

• The Federal Reserve Act established a system of 12 regional Federal Reserve banks, each associated with a geographical area called a Federal Reserve district

  • Ensures that different regions were represented in the national policymaking process

    • Regional Feds regularly assess economic conditions in their districts

Board of governors

the leadership of the Fed, consist of seven governors appointed by the president to staggered 14-year terms

Federal Open Market Committee (FOMC)

the committee that makes decisions concerning monetary policy

• Meets eight times a year to review the state of the economy and to determine monetary policy

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

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

Open-market operations

open-market purchases and open-market sales

Banking Panic

a situation in which news or rumors of the imminent bankruptcy of one or more banks leads bank depositors to rush to withdraw their funds

• The existence of fractional-reserve banking makes banking panics possible

  • Bank reserves are less than deposits, which means that banks do not keep enough cash on hand to pay off their depositors if they were all the decide to withdraw their deposits

    • Since bank reserves are less than deposits, a sufficiently severe panic could lead even financially healthy banks to run out of cash, forcing them into bankruptcy and closure

Deposit Insurance

a system under which the government guarantees that depositors will not lose any money even if their bank goes bankrupt

• Eliminates the incentive for people to withdraw their deposits when rumors circulate that the bank is in financial trouble

Velocity

a measure of the speed at which money circulates; the speed at which money changes hands in transactions involving final goods and services

• = (value of transactions) / (money stock)

• = (nominal GDP) / (money stock)

• = (price level x real GDP) / (particular money stock being considered-ex. M1 or M2)

Quantity equation

M x V = P x V

Monetary aggregates

measures of money supply defined by the Fed

Money supply process

the mechanism that determines the level of money supply

Three main players in the money supply process

1. The central bank- the government agency that oversees the banking system and is responsible for the conduct of monetary policy

2. Banks (depository institutions)- the financial intermediaries that accep deposits from individuals and institutions and make loans

3. Depositors- individuals and institutions that hold deposits in banks

Money supply

currency + demand (checking account) deposits

Reserves

the portion of deposits that banks have not lent

Bank deposit

bank reserves / desired reserve-deposit ratio

The Fed

has responsibility of conducting monetary policy and oversee and regulate financial markets

Monetary policy

deciding and managing the size of the nation’s money supply

• Monetary base- the sum of reserves and currency in circulation

Federal Funds Rate- the primary indicator of the stance of monetary  policy in the US; the interest rate on overnight loans of reserves (known as federal funds)

Open market operations

the Fed’s preferred method of monetary control

1. To increase the monetary base, the Fed could buy government bonds, paying with new dollars

Discount rate

the interest rate the Fed charges on loans to banks

1. To increase the monetary base, the Fed could lower the discount rate, encouraging banks to borrow more reserves

Reserve requirements

Fed regulations impose a minimum reserve-deposit ratio

1. To reduce the reserve-deposit ratio, the Fed could reduce reserve requirements

2. Reserve requirements are not usually used as a monetary policy tool

Interest on reserves

the Fed pays interest on banks reserves deposited with the Fed

1. To reduce the reserve-deposit ration, the Fed could pay a lower interest rate on reserves

Quantitative easing

outright purchases of financial assets (federal government bonds) through the creation of excess settlement balances (reserves)

• Works by bidding up the price of long term bonds thereby reducing the cost of borrowing in the economy

Forward guidance

statements about the future path of the policy rate

• A communication tool

• Works by anchoring market expectation about future interest rate decreases long term interest rate

• The effectiveness of forward guidance depends on the credibility of the central bank

Negative interest rate policy

a situation whereby central banks private banks on their deposits (a negative interest rate)

• Work by: encouraging banks to lend more (expansionary)

• But could be costly for banks by reducing their profitability, which may make them less likely to lend (contradictory)

Banking panics

occur when consumers believe one or more banks might be bankrupt

• Depositors rush to withdraw funds

• Everyone tries to withdraw before the bank runs out of money

• Banks have inadequate reserves to meet demand

• Banks close and depositors lose their money

• The Fed prevents bank panics by

  • Supervising and regulating banks

  • Loaning bank funds if needed

Deposit insurance

congress created deposit insurance in 1934 in response to the Great Depression

• Deposits of less than $250,000 will be repaid even if the bank is bankrupt

• Decreases incentive to withdraw funds on rumors

• The downside is with less risk, depositors pay less attention to whether banks are making prudent investments

Quantity theory of money

a simple theory linking the inflation rate to the growth rate of the money supply

• M x V = P x Y

  • M= money supply

  • P = Price level (CPI)

  • Y= Quantity of Output (Real GDP)

  • P x Y= value of output (nominal GDP)

  • V= velocity of money

predicts a one-for-one relationship between changes in the money growth rate and changes in the inflation rate

• If the central bank keeps the money supply stable, the price level will be stable

• If the central bak increases the money supply rapidly, the price level will rise rapidly

Velocity of money

the rate at which money circulates

• The number of times the average dollar bill changes hands in a given time period

• Velocity = (Price level x quantity of output) / (money supply)