Quiz

Suppose that, Investment is 500, the marginal propensity to consume is 0.9,

government expenditure = 200, autonomous level of consumption is 370, and

taxes are 200.

1. Determine the equilibrium level of output.

2. Calculate the change in equilibrium ΔY resulted from increasing government

expenditure by 50. what will be the new equilibrium of Y?

3. Calculate the change in equilibrium Y resulted from increasing taxes by 50.

what will be the new equilibrium Y?

4. Calculate the change in equilibrium Y resulted from increasing both

government expenditure & taxes by 50 each.

 The Money Supply
and the Federal 10
Reserve System
CHAPTER OUTLINE
An Overview of Money
What Is Money?
Commodity and Fiat Monies
Measuring the Supply of Money in the United States
The Private Banking System
How Banks Create Money
A Historical Perspective: Goldsmiths
The Modern Banking System
The Creation of Money
The Money Multiplier
The Federal Reserve System
Functions of the Federal Reserve
Expanded Fed Activities Beginning in 2008
The Federal Reserve Balance Sheet
How the Federal Reserve Controls the Money Supply
The Required Reserve Ratio
The Discount Rate
Open Market Operations
Excess Reserves and the Supply Curve for Money
LookingAhead
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 An Overview of Money

What Is Money?

- Money is one of the most important inventions of mankind.

- Economists consider money to be any asset that people

are generally willing to accept in exchange for goods and

services, or for payment of debts.

- Asset: anything of value owned by a person or a firm.

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Barter and invention of money

Suppose you are living before the invention of money,

- If you wanted to trade, you would have to barter, trading goods and

services directly for other goods and services. (the alternative to a monetary

economic)

- Trade would require a double coincidence of wants.

- Eventually, societies started using commodity money- goods used as

money that also have value independent of their use as money – like animal

skins or precious metals.

- The existence of money makes trading much easier and allows

specialization, an important step for developing an economy.

The functions of money
Money has three primary functions means of payment, a store of value, and a unit of
account.

Medium of exchange, or means of payment, What sellers generally accept and

buyers generally use to pay for goods and services.

A Unit of Account, A standard unit that provides a consistent way of quoting prices. “
book = 4 JOD , not 10 bananas. (measuring values in a standard manner).

Store of value An asset that can be used to transport purchasing power from one
time period to another. “ if you decide to buy something later”
Advantages of money over other stores of value,
1) Money is easily portable.
2) Easy to exchange for goods any time.
 The functions of money

Liquidity property of money The property of money that makes it a good

medium of exchange as well as a store of value: It is portable and readily

accepted and thus easily exchanged for goods.

The main disadvantage of money as a store of value is that the value of money

falls when the prices of goods and services rise.

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 Commodity and Fiat Money

Commodity money Items used as money that also have intrinsic value in

some other use. For example, prisoners of war made purchases with

cigarettes, quoted prices in terms of cigarettes, and held their wealth in the

form of accumulated cigarettes.

Fiat, or token, money refers to any money, such as paper currency,

that is authorized by a central bank or government body, and that does

not have to be exchanged by the central bank for gold or some other

commodity money.

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Where do prices comes from
 Measuring the Supply of Money

How much money is there in a nation?

So, what count as “money”?

M1, or transactions money Money that can be directly used for transactions.

It is the narrowest definition of the money supply.

M1 ≡ currency held outside banks + demand deposits + traveler’s checks +

other checkable deposits

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 Measuring the Supply of Money

Near money close substitutes for transactions money, such as savings

accounts and money market accounts.

M2, or broad money M1 plus savings accounts, money market accounts, and

other near monies.

M2 ≡ M1 + savings accounts + money market accounts + other near monies

Beyond M2

There are no rules for deciding what is and is not money. This poses problems
for economists and those in charge of economic policy. However, for our
purposes, “money” will always refer to transactions money, or M1.

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 The Private Banking System

Financial intermediaries Banks and other institutions that act as a link

between those who have money to lend and those who want to borrow money.

- Collect deposits from savers

- Provide loan to borrowers

The main types of financial intermediaries are commercial banks, followed by

savings and loan associations, life insurance companies, and pension funds.

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 How Banks Create Money
A Historical Perspective: Goldsmiths
The origins of the modern banking system date back to the fifteenth and sixteenth

centuries, when gold was used as money but was also inconvenient to carry

around. People began to place their gold with goldsmiths for safekeeping. The

receipts issued to the depositor became a form of paper money. The receipts were

backed 100 percent by gold.

The goldsmiths found that people did not come often to withdraw gold. People

simple exchanged their paper receipts. So the goldsmiths found “extra” gold sitting

around that they could lend out, effectively changing from depositories to banklike

institutions that had the power to create money. Without adding any more gold to the

system, the goldsmiths increased the amount of money in circulation.

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 Goldsmiths-turned-bankers did face certain problems. Once they started
making loans, their receipts outstanding (claims on gold) were greater than the
amount of gold they had in their vaults at any given moment.

In normal times, goldsmiths were safe, but once people started to doubt the
safety of the goldsmith, they would be foolish not to demand their gold back
from the vault.
Run on a bank Occurs when many of those who have claims on a bank
(deposits) present them at the same time.

Today’s bankers differ from goldsmiths—today’s banks are subject to a

“required reserve ratio.”

Goldsmiths had no legal reserve requirements, although the amount they

loaned out was subject to the restriction imposed on them by their fear of
running out of gold.
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 The Modern Banking System
A Brief Review of Accounting
Assets − Liabilities ≡ Net Worth
or
Assets ≡ Liabilities + Net Worth

Assets are things a firm owns that are worth something. For a bank, these
assets include the bank building, its furniture, its holdings of government
securities, bonds, stocks, and so on. Most important among a bank’s assets,
for our purposes at least, are the loans it has made.

Other bank assets include cash on hand (sometimes called vault cash) and
deposits with the U.S. central bank.

Federal Reserve Bank (the Fed) The central bank of the United States.

A firm’s liabilities are its debts—what it owes. A bank’s most important liabilities
are its deposits. Deposits are debts owed to the depositors because when you
deposit money in your account, you are in essence making a loan to the bank.

Net worth represents the value of the firm to its stockholders or owners.
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 FIGURE 10.1 T-Account for a Typical Bank (millionsof dollars)
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).

Reserves The deposits that a bank has at the Federal Reserve bank plus its
cash on hand.

Required reserve ratio The percentage of its total deposits that a bank must
keep as reserves at the Federal Reserve.

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 The Creation of Money

Excess reserves The difference between a bank’s actual reserves

and its required reserves.

excess reserves ≡ actual reserves − required reserves

FIGURE 10.2 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.

When loans are converted into deposits, the supply of money will
increase.
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 FIGURE 10.3 The Creation of Money When There Are Many Banks

In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a

loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then
written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process
continues with bank 2 making loans and so on.
In the end, loans of $400 have been made and the total level of deposits is $500.

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 The Money Multiplier

An increase in bank reserves leads to a greater than one-for-one increase in

the money supply.

Economists call the relationship between the final change in deposits and the
change in reserves that caused this change the money multiplier.

Money multiplier The multiple by which deposits can increase for every dollar
increase in reserves; equal to 1 divided by the required reserve ratio.

1
moneymultiplier
Required Reserve Ratio (RRR)

In the United States, the required reserve ratio varies depending on the size of
the bank and the type of deposit. For large banks and for checking deposits,
the ratio is currently 10 percent, which makes the potential money multiplier
1/.10 = 10. This means that an increase in reserves of $1 could cause an
increase in deposits of $10 if there were no leakage out of the system.

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 Functions of the Federal Reserve
The Fed is the central bank of the United States. Central banks are sometimes
known as “bankers’ banks.”

From a macroeconomic point of view, the Fed’s crucial role is to control the
money supply.

The Fed also performs several important functions for banks, such as clearing
interbank payments, regulating the banking system, managing exchange rates
and the nation’s foreign exchange reserves, and assisting banks in a difficult
financial position.

It is often involved in intercountry negotiations on international economic

issues.

Besides facilitating the transfer of funds among banks, the Fed is responsible
for many of the regulations governing banking practices and standards.

lender of last resort One of the functions of the Fed: It provides funds to
troubled banks that cannot find any other sources of funds.

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 The Federal Reserve Balance Sheet
TABLE 10.1 Assets and Liabilities of the Federal Reserve System, January 30, 2013
(Billions of Dollars)

Assets Liabilities

Gold $ 11 $ 1,156 Currency in circulation

U.S. Treasury securities 1,710 1,645 Reserve balances

Federal agency debt securities 75 71 U.S. Treasury deposits

Mortgage-backed securities 966 180 All other liabilities and net worth

All other assets 290 $3,052 Total

Total $3,052

Gold is trivial. Do not think that this gold has anything to do with money in
circulation.
U.S. Treasury securities are the traditional assets held by the Fed.
The new assets of the Fed (since 2008) are federal agency debt securities
and mortgage-backed securities.
Currency in circulation accounts for about 38 percent of the Fed’s liabilities.
Reserve balances account for about 54 percent of the Fed’s liabilities.
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 How the Federal Reserve Controls the Money Supply

The money supply is equal to the sum of deposits inside banks and the
currency in circulation outside banks.

If the Fed wants to increase the supply of money, it creates more reserves,
thereby freeing banks to create additional deposits by making more loans. If it
wants to decrease the money supply, it reduces reserves.

Three tools are available to the Fed for changing the money supply:

(1) Changing the required reserve ratio (RRR).

(2) Changing the discount rate.

(3) Engaging in open market operations.

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 The Required Reserve Ratio

TABLE 10.2 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 Commercial Banks
Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

Panel 2: Required Reserve Ratio = 12.5%
Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans $700 (+ $300)
(+ $300)

Note: Money supply (M1) = currency + deposits = $900.

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 - Decreases in the required reserve ratio allow banks to have more
deposits with the existing volume of reserves.
As banks create more deposits by making loans, the supply of money
(currency+ deposits) increases.

- The reverse is also true: If the Fed wants to restrict the supply of
money, it can raise the required reserve ratio, in which case banks will
find that they have insufficient reserves and must therefore reduce
their deposits by “calling in” some of their loans.
The result is a decrease in the money supply.

Therefore, inverse relationship between RRR and MS.

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 The Discount Rate
Discount rate The interest rate that banks pay to the Fed to borrow from it.

When banks increase their borrowing, the money supply increases.

TABLE 10.3 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 Commercial Banks
Assets Liabilities Assets Liabilities

Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320

Note: Money supply (M1) = currency + deposits = $480.

Panel 2: Commercial Bank Borrowing $20 from the Fed

Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities

Securities $160 $100 Reserves Reserves $100 $500 Deposits

(+ $20) (+ $20) (+ $300)
Loans $20 $80 Currency Loans $420 $20 Amount owed to
(+ $100) Fed (+ $20)

Note: Money supply (M1) = currency + deposits = $580.

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 Open Market Operations

Open market operations, 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.

When the Fed purchases a security, it pays for it by writing a check

that, when cleared, expands the quantity of reserves in the system,
increasing the money supply. When the Fed sells a bond, private
citizens or institutions pay for it with their bank deposits, which reduces
the quantity of reserves in the system.

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 The Mechanics of Open Market Operations

TABLE 10.4 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 Jane Q. Public
Assets Liabilities Assets Liabilities Assets Liabilities
Securities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts
$80 Currency Loans $80 $5 Net Worth
Note: Money supply (M1) = Currency + Deposits = $180.
Panel 2
Federal Reserve Commercial Banks Jane Q. Public
Assets Liabilities Assets Liabilities Assets Liabilities
Securities $95 $15 Reserves Reserves $15 $95 Deposits Deposits $0 $0 Debts
( $5) ( $5) ( $5) ( $5) ($5)
$80 Currency Loans $80 Securities $5 $5 Net Worth
(+ $5)
Note: Money supply (M1) = Currency + Deposits = $175.
Panel 3
Federal Reserve Commercial Banks Jane Q. Public
Assets Liabilities Assets Liabilities Assets Liabilities
Securities $95 $15 Reserves Reserves $15 $75 Deposits Deposits $0 $0 Debts
( $5) ( $5) ( $5) ( $25) ( $5)
$80 Currency Loans $60 Securities $5 $5 Net Worth
( $20) (+ $5)
Note: Money supply (M1) = Currency + Deposits = $155.

The final equilibrium position is shown in panel 3, where commercial banks have reduced their loans by $20 billion. This
corresponds exactly to our earlier analysis of the money multiplier. The change in money ( -$25 billion) is equal to the
money multiplier (5) times the change in reserves (-$5 billion).
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 The Mechanics of Open Market Operations

We can sum up the effect of these open market operations this way:

■ 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.

■ 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.

Open market operations are the Fed’s preferred means of controlling the
money supply for several reasons. They can be used with some precision; are
extremely flexible; and, have a fairly predictable effect on the money supply.

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 Excess Reserves and the Supply Curve for Money

FIGURE 10.5 The Supply of Money

If the Fed’s money supply behavior is not influenced by the interest rate, the money
supply curve is a vertical line.
Through its three tools, the Fed is assumed to have the money supply be whatever
value it wants.
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