"Money

1. "Money is whatever is generally accepted in exchange for goods and services — accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power to be used for buying still other goods and services.” — Milton Friedman (1992)

2. What is Money? • Amedium of exchange:Used to buy and sell goods and services. • Avoids barter • 2. A store of value:Allows transfer of purchasing power from one period to another. • A measure of value:Converts worth to a monetary value. • A standard of deferred payment:Makes future payments possible.

3. The Value of Money • Commodity Money: • has value itself, deer skins • Fiat money: • just because

4. Criteria for being a Medium of Exchange • Acceptable: • used by most people • Standardized quality : • all looks the same • Durable: • goes through the wash • 4. Valuable • large enough and portable • 5. Divisible • allows impulse buying

5. Two basic measurements of the money supply are M1 and M2: • The components of M1 are: • Currency • Checking Deposits(including demand deposits and interest-earning checking deposits) • Traveler's checks • M2(a broader measure of money)includes: • M1, • Savings, • Time deposits under $100,000, and, • Money mutual funds The Supply of Money

6. Measuring the Money Supply, August 2011 = $9,545 billion = $2,108.8 billion M1 M2

7. $1,596 $8,328 The Composition of Money in the U.S. The M1 and M2 Money Supply of the U.S –––––––––– (as of May 2009) –––––––––– Money Supply, M1 (in billions) Currency (in circulation) $850 Demand deposits 407 Other checkable deposits 334 Traveler’s checks 5 Total M1 $1,596 Money Supply, M2 (in billions) M1 $1,596 Savings deposits a 4,445 Small time deposits 1,308 Money market mutual funds 979 Total M2 $8,328 a Including money market deposit accounts.Source: http://www.federalreserve.gov. • The size and composition of the two most widely used measures of U.S. money supply (M1 & M2) are shown above.

8. M1, M2, or not? b b a a a a c c c c 1. __ A $100 bill 2. __ A 6-month certificate of deposit 3.__ A $10,000 retirement account invested in stocks 4. __ A $50 traveler’s check 5. __ A $5,000 American Express credit line 6. __ A quarter 7. __ A $1 off coupon clipped from the paper 8. __ A $100 balance in a checking account 9. __ A $200 balance in a savings account 10. __ A $10,000 treasury bill

9. Interest-earningcheckable deposits M1 $309 $312 Demand deposits Currency $672 The Changing Nature of M1 Billions of $ Total $1,293 1,350 1,200 1,050 900 750 600 450 300 150 1970 1975 1980 1985 1990 1995 2000 2003 • In the 1980s, interest-earning checking accounts M1 • In the 1990s, money market mutual funds M1

10. Interest-earningcheckable deposits Demand deposits Currency $309 The Changing Nature of M1 Billions of $ M1 Total $1,388 900 750 600 450 $761 $318 300 150 1970 1975 1980 1985 1990 1995 2000 2005 • In the 1980s, interest-earning checking accounts M1 • In the 1990s, money market mutual funds M1

11. Financial Depository Institutions • Function: • accept and maintain deposits. • make loans.

12. Financial Depository Institutions • Types:. • Commercial Banks. • Savings and Loans • Credit Unions • Savings Banks.

13. Consolidated Balance Sheet of Commercial Banking InstitutionsApril 2009(billions of $) Assets Liabilities Vault cash $ 40 Checking deposits $ 600 Reserves at the Fed 672 Savings and time deposits 6,851 Loans outstanding Borrowings 7,051 2,400 U.S. government securities 1,265 Other liabilities 928 Other securities 1,412 Net worth 1,291 Other assets 1,630 Total $ 12,070 $ 12,070 The Functions of Commercial Banking Institutions • Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities). • Most of these deposits are invested and loaned out, providing interest income for the bank. • Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.

14. Balance Sheet for a Large Bank, 12/31/10 The items on a bank’s balance sheet of greatest economic importance are its reserves, loans, and deposits. . The left side of the balance sheet always equals the right side.

15. Fractional Reserves • Banks maintain only a fraction of their assets (deposits) as reserves to meet the requirements of depositors. • an decrease in required reserves lets banks make more loans, expand the money supply

16. Creating Money • Printing Money • Making Loans • a. Key Ingredients: • Deposits – Household savings • Required Reserves – money held at the bank or at the FRS (around 10%) • Excess Reserves – loan able funds= Deposits – Required Reserves A depository institution can make loans up to the value of its excess reserves

17. Loan Making Main Street Bank Situation: Demand deposits = $50,000 Reserve requirement = 10 % Actual reserves at bank = $10,000 How much can they lend? Excess Reserves: Demand deposits = $50,000 Reserve requirement= 10 % Actual reserves = $10,000 - Required reserves = $5,000 = Excess reserves = $5,000

18. Loan Making Excess Reserves ($5,000) can be loaned By making a loan, the bank has created money. The original deposits are still in Main Street Bank, but now there is an additional $5,000 out floating around.

19. Creating Money If the Excess Reserves are loaned The borrowed money is spent and deposited at another bank. The second bank’s reserves are now up $5,000 - it must keep 10% or $500 - it can then loan out $4,500 ($5,000 – $500) This process can be repeated at each step. 10% of the money is lost at each step The more that is required to be held in reserve, the less money can be created The lower the reserve requirement, the greater the amount of money that can be created

20. Creating Money from New Reserves New cash deposits:Actual Reserves Potential demand deposits created byextending new loans NewRequired Reserves Bank Initial deposit (bank A) $1,000.00 $200.00 $800.00 Second stage (bank B) 800.00 160.00 640.00 Third stage (bank C) 640.00 128.00 512.00 Fourth stage (bank D) 512.00 102.40 409.60 Fifth stage (bank E) 409.60 81.92 327.68 Sixth stage (bank F) 327.68 65.54 262.14 Seventh stage (bank G) 262.14 52.43 209.71 All others (other banks) 1,048.58 209.71 838.87 Total $5,000.00 $1,000.00 $4,000.00 • When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

21. The Money Multiplier From the table a deposit of $1000, with a 20% reserve requirement led to a $4000 expansion of the money supply Is there a pattern here? Yes!!! It just takes 3 easy steps

22. The Steps 1. Find the reciprocal of the required reserve 1/20% = 1/1/5= 5 2. Multiply the initial change in the excess reserves by the money multiplier $1000 * 5 = $5000 • Subtract out the initial change • $5000 - $1000 = $4000

23. Problem 1 • Deposit of $10,000 • ________ • ________ • ________ • Required reserve 10% • Increase in the money supply? • 10,000 c. 100,000 • 9,000 d. 90,000 • ________ • ________ • ________ How about if the reserve requirement was 20%? • 200,000 c. 100,000 • 40,000 d. 50,000

24. Problem 2 • Deposit of $16,000 • ________ • ________ • ________ • Required reserve 25% • Increase in the money supply? • 144,000 c. 80,000 • 48,000 d. 64,000 • ________ • ________ • ________ How about if the reserve requirement was 20%? • ________ • ________ • ________ How about if the reserve requirement was 10%?

25. The Effect of Loaning Money 1. Loan making changes the money supply 2. Increases in loans leads to increased spending which increases the money supply. 3. BUT, decreases in loan making, or even paying back a loan decreases the money supply.

26. Reserve Requirements (Reserve Ratios) for Banks and Thrifts, 2003 Type of Deposit Current Requirement Limits Checkable Deposits $0 - $6 million 0 % 3% $6 - $42.1 million 3 3 Over 42.1 million 10 8-14 Non-checkable non-personal savings and time deposits 0 0-9

27. The Federal Reserve System FRS

28. The Federal Reserve System • Created in 1913 • Responsible for: • a. overseeing the money supply • b. coordinating commercial bank operations • c. regulating depository institutions

29. The FRS Organization Federal ReserveBoard of Governors 7 members appointed by the president,with the consent of the U.S. Senate 12 Federal ReserveDistrict Banks Open MarketCommittee (25 branches) Board of Governors &5 Federal Reserve Bank Presidents (alternating terms, New York Bankalways represented). Commercial BanksSavings & LoansCredit UnionsMutual Savings Banks The Public: Households & businesses • The Board of Governors is at the center of the banking system in the U.S. • The seven members of the Board of Governors also serve on the Federal Open Market Committee • The FOMC is a 12-member board that establishes Fed policy regarding the buying and selling of government securities.

30. Board of Governors – • 7 members appointed by President • - 14 yr terms at 2 yr intervals for continuity & independence • -not more than one from each district 2010 2000 2002 2004 2006 2008 2012 2014 Staggered 14 Year Terms http://www.federalreserve.gov/

31. The FRS Districts 1 9 2 3 7 12 4 . 10 (Board of Governors) 8 5 6 11 • Each district bank monitors the commercial banks in their region and assists them with the clearing of checks. • The Board of Governors of the Federal Reserve System is located in Washington D.C.

32. The FRS Regions and Branches 1 9 2 3 7 12 4 . 10 8 5 6 11 • ____________________ • ____________________, ____________________ • ____________________ • _________________, _________________, _________________ • ________________, _________________, _________________, • _________________, ________________, _________________, _________________, _________________, _________________ • _________________, _________________ • _________________, ________________, _________________, _________________ • _________________, _________________ • _________________, ________________, ________________, __________________ • _________________, _________________, _______________, • _________________, ________________, _________________, _________________, _________________, _________________

33. The FRS Regions and Branches 1 Boston 2 New York City, Buffalo 3 Philadelphia 4 Cleveland, Pittsburgh, Cincinnati 5 Richmond, Baltimore, Charlotte 6 Atlanta, Nashville, Birmingham, Miami, Jacksonville, New Orleans 7 Chicago, Detroit 8 St. Louis, Louisville, Memphis, Little Rock 9 Minneapolis, Helena 10 KC, Denver, Omaha, Oklahoma City 11 Dallas, San Antonio, El Paso 12 SF, Salt Lake City, LA, Port., Seattle, Honolulu

34. 2. Federal Open Market Committee -12 members = 7 Governors (for majority) plus 5 Pres or VP from 1 NY 2 Bost, Phila, or Richmond, 3 Atl, Dallas, or StL 4 Minn, KC, or SF, LA 5 Clev, or Chicago set policy onbuying & selling bonds on openmkt 3. Federal Advisory Council outsiders 12 members - 1 each selected by Board of each Region

35. The Functions of the US Treasury 1. Controls the Federal Budget 2. Borrows money for deficits 3. Issues Securities

36. The Functions of the Fed 1. Supervise and Examine Member Banks Make sure they are following the rules 2. Maintain Reserve Accounts Makes clearing check easier 3. Control Currency Circulation Replace money or increase or decrease money in circulation 4. Clear Checks Moves checks from region to region 5. Act as Fiscal agent for the US Government Borrows, writes checks, takes deposits

37. = * * Output Velocity Money Price The Quantity Theory of Money Y P M V M Y V P - the amount of money in circulation - the number of times each $ is spent in a year (considered to be stable) - the level of prices - the actual output of goods and services

38. = * * = * • PY Total Sales (GDP) Y =output Money Velocity Price The Quantity Theory of Money Y P M V • If V and P are constant, then an increase in M will lead to a proportional increase in Y GDP increases. • but if V and Y are constant (at full employment), then an increase in M will lead to a proportional increase in P =Inflation.