Money and Banking, the Fed,

1. Money and Banking, the Fed, Money Creation, & Monetary Policy Monetary Policy 1. Discount Rate 2. Reserve Ratio 3. Bonds 4. (NEW) [TAF]Term Auction Facility Ben Bernanke

2. There is$820billionin currency [notes& coins]. [2/3 is overseas] Money and Banking Money= paper notes + coins + Demand Deposits [52%] [2%] [46%] “Anything you can buy a candy bar with”

3. . 1. Three functions (roles) of money a. medium of exchange b. unit of account c. store of value 2. What constitutes money in our economy? (paper dollars-52%) (coins-2%) b. DD-46% 3. What “backs” the money supply? (gold/silver/the faith of the “G”) 4. Explanation of the demand for money. Dt + Da = DM 5. The four-part make-up of the Federal Reserve a. Board of Governors b. FOMC c. 12 Fed Banks d. Member banks Money– any good widely accepted for goods and services or repayment of debt. Money is anything generally acceptable as a medium of exchange. Objectives For Money and Banking a.Currency “Faith” of the “G”

4. 7th-G-Chicago (1) 8th-H-St. Louis (3) 9th-I-Minneapolis (1) 10th-J-Kansas City (3) 11th-K-Dallas (3) 12th-L-San Francisco (4) 1st-A-Boston(0) 2nd-B-New York (1) 3rd-C-Philadelphia(0) 4th-D-Cleveland (2) 5th-E-Richmond (2) 6th-F-Atlanta (5) Paper notes printedat: 1. FW Currency Center 2. Washington D.C. Coins minted at: 1. Denver 2. Philadelphia 3. San Francisco

5. Dollar Decoded Bills are crowded with numbers and letters that help the U.S. Treasury track printing errors & authenticate currency. Here’s what many of them mean: Fed bank that issued the bill [Chicago] Last letter tells how many times serial number has run Number corresponds to letter in circle indicating issuing Fed bank. First letter corresponds to issuing Fed bank

6. Money and Banking Moneyis thegrease that lubricates the economic machineryof the world. It reduces the friction of the voluntary exchange. Too little oil can leave some parts creaking; too much oil can gum up the works. Similarly, too little or too much in circulation makes exchange more difficult and creates economic problems. “Money is the only commodity that is good for nothing but to be gotten rid of. It will not feed you, cloth you, shelter you, or amuse you unless you spend it or invest it. People will do almost anything for money and money will do almost anything for people.

7. The Advantages of a Monetary System Over a Barter System

8. Barter – goods and services were traded without the exchange of money. However, before trade could occur, there had to be a “double coincidence of wants”. Each trader had to have something the other wanted. I would love to sell you these shoes but I can’t eat chicken, due to my bad teeth, caused by smoking. I’ll trade you a chicken for a pair of shoes. In a barter economy a chicken farmer who wants to buy shoes may have to first trade chickens for apples and then apples for shoesbecause the guy selling shoes wants only apples. Money eliminates this problem.

9. . It isless expensiveto use money. Using moneysaves timeandtime ismoney. It isless expensiveto use money. The“calculation of exchange”isfast and easy because whatever the price is, you pay that amount. Here’s $3.00 for one gallon. $3.00 The“calculation of exchange”bybartering is much slower than the“calculation of exchange” in amonetary system.

10. The monetary system enables the“calculationof exchange” to go much faster. • Money is also easier to tax. • So a monetary system is betterthan abarter system.

11. Three FUNCTIONS OF MONEY 1.Medium of Exchange [any asset that sellers will accept as payment for g/s] Medium means “something in the middle”, so money is a“medium of trade between buyers and sellers” because it can be exchanged for something else. Avoids “double coincidence of wants” that bartering requires. You would have to have a trading partner who “wants to sell you goods you want to buy”and“wants to buy goods you want to sell.” Liquidity– how easily an asset can be converted intocash without any additional expense.[Cash has 100% liquidity]

12. Three FUNCTIONS OF MONEY $249.00 2.Unit of Account [measuring the relative value of goods by stating prices] Example: Microsoft Stock is selling for $50 a share. The new Jag is selling for $32,000. A $2 item is twice as valuable as a$1 item. Money is like a yardstick. People use it to compare the worth of things that they buy and sell.

13. Three FUNCTIONS OF MONEY Greek Coin 2,500 years old 3. Store of Value[storing wealth from one point in time to another] [doesn’t wear out easily and holds up to inflation] Ability of money to hold value over time [Money that lacked durability or did not hold up well toinflation would not make good money [would not store value]. Ice cream cones would suffer monetary meltdown, become a sticky puddle. If money suffers high inflation, it causes the value of money to “melt.” Other desirable qualities for money are: A. Scarcity B. Portability C. Divisible D. Difficult to counterfeit

14. Two Types of Money • Commodity Money:something that performs the function of money and has alternative, non-monetary uses. Gold, silver, cigarettes, corn • Fiat Money: something that serves as money but has no other important uses. • Paper notes • Coins Alternative uses such as …

15. Money In The American Economy Currency + DD equal M1[Spendable Money] M1 M2 MZM Also included here would beTravelers checks, Checklike deposits[NOWand Super NOWAccts] M1 Completely Liquid $1,375 [billions] 2%52% 46% M1 + savings deposits, small TDs [like CDs & bonds] under $100,000,& MMMFs for individuals=M2 M2+ 2 more categories=[money zero maturity] MZM [money available at “0” cost to HH & businesses] [ So, subtract small TDs; add MMMFs owned by businesses –no penalty to spend MMMFs] “V” – how many times a dollar changes hands in a year $6,758 $6,934 [Billions] V = GDP[Y]/M1 = 13 tr./1.3 tr. = 10

16. What about Credit Cards? Are they money? They are not “plastic money.” They do serve as a: 1. medium of exchange& the 2. credit card statementservesas aunit of account. 3. but, they donot have a store of value. If the credit card company goes out of business or decides not to honor your card, it is worthless. They are not money because they don’t store value.

17. What about Debit Cards? Are they money? Debit cards aremoney. They serve as a: 1. medium of exchange; they also serve as a 2. store of value(not an extension of credit); and 3. debit card statementsserve as a unit of account. Debit Card

18. If a robber says, “Give me your money”, This is what the reply could be. “Let’s see, do you want the: 1. Cashin my pocket, my 2. Debit Card, my 3. Traveler’s Checks, my 4. NOW or Super NOWAccount, my 5. Money Market Account or - may I just write you a 6. Check “Give me your money.”

19. Our Money Is Growing More Abstract. Money has grown increasingly more abstract - from a physical commodity, - to a piece of paperrepresenting a claim on a physical commodity, - to a piece of paper of no intrinsic value, - to an electronic entryrepresenting a claim on apieceof paper of no intrinsic value. [just a Federal Reserve note]

20. The Value of Money and Price Level Value of Money Prices The value of money goesin the opposite direction of the general price level. Or, the amount a dollar will buyvaries inversely with the price level.

21. The Interest Rate and oldBond Prices $1,000 x .08 = $80 $1,333 x .06 = $80 $800 x .10 = $80

22. Normal,Flat, &InvertedYield Curves[and theLiquidity Trap] So, anInverted Yield Curvewould exist in an interest rate environment in which short-term bonds  have a higher yield than long-term bonds, caused byinflation now but expect the economy to slow in the future. Short-term bonds yield less than long-term bonds Normal yield curve 8% The economy is predicted to grow. Yield on bonds 6% Flat yield curve Short-term & long-term bonds yield about the same Transition between normal & inverted curves 5% Inverted yield curve 4% Long-term bonds yield less than short-term bonds Rare – predictor of recession 1 Yr 1 Yr 10Yr 30 Yr Maturity of bonds An economy's bond rates are more apt to have an inverted yield curve when: (A) the economy's real output is increasing. (B) the economy is experiencing inflation. (C) the economy is exporting more. (D) the economy's price level is constant. (E) the economy is importing more.

23. 1. The most important function of moneyis as a: (unit of account/store of value/medium of exchange). 2. If you are estimating that it will take $5,000to escort Suzie Rah Rahto the prom so that you can demonstrate your talent with the“Econ Rap,”you are using money as a: (unit of account/store of value/medium of exchange). 3. If you place some of your Kroger’s earnings in a safety deposit box so that you can get your boyfriend, Roger Rocket, a pair of roller blades for Christmas, you are using money as a: (unit of account/store of value/medium of exchange). 4. Estimating expenses for A&M at $16,001illustrates money serving as a (unit of account/store of value/medium of exchange). 5. If Suzie Nomicswrites a check for a new Honda, she is using money as a (unit of account/store of value/medium of exchange). 6. M1 [also called transactions money or medium of exchange money or “spendable money”] is comprised of coins, paper money and(gold certificates/checkable deposits). 7. The major component of M1is (currency/checkable deposits). 8. The volume of M1is closer to ($1/$3/$4) trillion. 9. (M1/M2)includes non-checkable savings accounts, MMA’s & TDs under $100,000. 10. (Fiat/Commodity) money is money because the G says that it is [G fiat]. 11. The value of money varies(directly/inversely) with the price level. 12. If the price index increases from 100 to 120, the value of the dollar will fall by (one third/one fifth/one fourth). 13. The money supply is backedby (silver/gold/the government). Money NS 1-13

24. Remember, When It Comes To Monetary Policy: "BUY" means? "BIGGER" "SELL" means? "SMALLER"

25. 3 Tools of Monetary Policy 1. Discount Rate – banks borrow from the Fed (symbolic) 2. Required Reserve - % of DD which cannot be loaned. 3. Buy/SellBonds – government debt - 3 mo., 6 mo., & 1 year; purchase price:$10,000 - 2 yr., 3 yr., 5 yr.,($5,000), & 10 yr., ($10,000) - 30 years with purchase of $1,000 Federal Funds Target Rate – overnight lending rate between banks to correct a temporary imbalance in reserves. Inflation Raise Raise Sell Recession Lower Lower Buy AS AS AD LRAS AD AD AD PrimeRate-loan rate to the best (prime)customers. Y*YI YR Y* Real GDP 2.3% 17 increases 4%

26. “Easy Money” During Recessions “Students, should the Fed buy or sell bonds to jumpstart this economy?” MS1 MS2 DI Investment Demand 10 8 6 0 10 8 6 0 Nominal Interest Rate Buy DM If there is RECESSION MS will be increased. Money Market QID1 QID2 AD1 [C+Ig+G+Xn] AD2 LRAS “Easy Money” – (Buy/Sell) bonds, which(increase/decrease) MS, which (increase/decrease) interest rates, which (appreciate/depreciate) the dollar, which(increase/decrease) C, Ig, & Xn, which (increase/decrease) AD & therefore, PL, GDP, & emp. AS Price level Jobs are tough to get. PL2 E2 PL1 E1 YRReal GDP Y*

27. “Tight Money” To Fight Inflation “Now, should I buy or sell?” DI MS1 MS2 Dm 10 8 6 0 10 8 6 0 Investment Demand Nominal Interest Rate Sell If there is INFLATION, MS will be decreased. QID1 Money Market QID2 AS LRAS “Tight Money” – (Buy/Sell) bonds, which(incr/decr) the MS, which (incr/decr) in. rates, which (apprec/deprec) the dollar, which (incr/decr) C, Ig, & Xn, which (incr/decr) AD, PL,& GDP. AD2 “I’ll get rid of some money.” P1 E1 P2 E2 AD1 YI Y*

28. Demand For Money [Demand for “cash in hand”] 10 7.5 5 2.5 0 Nominal Interest Rate Dt 0 50100150 200 250 300 Money demanded (bil.) For Daily, Weekly, & Monthly Transactions Mortgage/rent Utilities Gas Food Emergency money Tuition for kids Christmas gifts Transactions Demand, Dt M1 Independent of interest rate Direct with Nominal Y Medium of Exchange M1 Valentine candy forwife Gift for thegirlfriend We keep this transaction money(M1) in our wallet, under our mattress, or in our checking accounts.

29. 10 7.5 5 2.5 0 10 7.5 5 2.5 0 Nominal Interest Rate Rate of interest, i (percent) Dt Da 0 50 100 150 200 250 300 0 50100150 200 250 Amount of money demanded (billions) Amount of money demanded (billions) THE Total DEMAND FOR MONEY + = Total demand for money, Dm Transactions Demand, Dt Asset Demand, Da Da [M2] – store of value money Money that we don’t need for daily, weekly, or monthly transactions. We will invest more of it the higher the interest rate. We will hold less because the opportunity cost increases. “Walking around” money M1 Dt Independent of the interest rate Da 10% 8% 6% 4% 2% 0 “I’m losing more interest, the higher the I.R.” Interest Rate Opportunity Cost Da [hold less] Interest Rate Opportunity Cost Da [hold more] CDs or 5% Da varies inversely with the interest rate. 1% 0 50 100 150 200

30. 10 7.5 5 2.5 0 10 7.5 5 2.5 0 10 7.5 5 2.5 0 Rate of interest, i (percent) Nominal Interest Rate Rate of interest, i (percent) Dm Dt Da 50 100 150 200 250 300 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) THE DEMAND FOR MONEY + = Transactions Demand, Dt Asset Demand, Da Total demand for money, Dm [independent][inverse] M 10% 7.5% 5% 2.5% 0 50 100 150 200 250 300

31. 10 7.5 5 2.5 10 7.5 5 2.5 Rate of interest, i (percent) Nominal Interest Rate Dt Da 0 50 100 150 200 250 300 Amount of money demanded [billions] Amount of money demanded [billions] The Demand for Money + = Transactions Demand, Dt Asset Demand,Da Total demand for money, Dm MS2 MS1 MS 10 7.5 5 2.5 0 E Rate of interest, i (percent) 5 Dm 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Money market 1. At equilibrium 5% I.R., the amount of money demanded for transactions is (0/50/100) and the amount demanded as an asset is (0/50/100). 2. If the interest rate were 10%, the amount of money demanded for Dt would be (0/50/100) & the amount demanded as an asset would be (0/50/100). 3. Da slopes down because lower in. rates (incr/decr)the cost of holding money.

32. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market The Dm curve represents the quantity of money people are willing to hold at various interest rates. 7.5 5 2.5 0 MS Dm E Nominal Interest Rate 50 100 150 200 250 300 Money Market Due to a recession, suppose the money supply is increasedfrom $200 billion to $250 billion.

33. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market A temporary surplus of $50 billionbeyond which the people wish to hold, so money becomes a “hot potato”. MS2 MS1 S1 S2 10 7.5 5 2.5 Dm P2 Price of Bonds P1 They react by buying bonds [pushing bond prices up] to meet the desired level of liquidity. Nominal Interest Rate E # of Bonds E 0 50 100 150 200250 300 Money Market

34. Liquidity Trap MS1 MS2 1% LRAS SRAS Dm AD AD Nominal Interest Rate PL YD GDP E 0 500 Money Market Liquidity Trap – in a stagnant economy with interest rates near or at zero, an increase in MS fails to stimulate AD, so recession or depression gets worse. With low returns expected on financial investments, people hoard their money. Banks are unwilling to lend in a slack economy.Fiscal policy is needed here.

35. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market Due to inflation, suppose the money supply is decreased from $200 billionto $150 billion. 7.5 5 2.5 MS Dm E Nominal Interest Rate 0 50 100 150 200 250 300 Money Market

36. The Money Market A temporary shortage of money will require the sale of some assets [bonds-which will make their price fall] to meet the money shortage need. MS2 MS1 Dm S2 S1 10 7.5 5 P1 Nominal Interest Rate Price of Bonds P2 E # of T-bills 0 50 100 150 200 250 300 Money Market

37. Let’s Review [Dm] One More Time

38. MS • If interest = i1 • Dm > MS • People sell interest bearing assets to hold more money • Price of financial assets [bonds] fall and interest rates rise E i i1 Dm M2 M1 Equilibrium In The Money Market Nominal interest rate Money Market

39. MS2 • The Fed wants to lower in. rates • Fed buys bonds • The money supply increases • Creates a surplus of money • People buy interest bearing assets [bonds] • Non-money asset prices rise and interest rates fall F I2’ M2 The Fed Lowers The Nominal Interest Rate Dm MS1 Nominal interest rate i1 E M1 Money Market

40. MS & Money Market Equilibrium • The Fed wants to raise interest rates • Fed sells bonds • The money supply decreases • Creates a shortage of money • People sell non-money assets[bonds] • Non-money asset prices[bonds] fall and the interest rate increases

41. Macro Free Response 2007 1. [3 pts] Assume that declining stock market prices in the U.S. cause many U.S. financial investors to sell their stocks and increase their money holdings. (a) Draw a correctly labeled graph of the money market and show the impact of the financial investors’ actions on each of the following. (i) Demand for money (ii) Nominal interest rate MS DM2 DM1 • Answers for 1. (a) (i) [2 points] • (a) (i) In an effort to preserve wealth, • investors sell off stocks when market • prices begin to decline. These new • money holdings will increase the • asset [speculative] demand for money. • In the volatile market, investors will • hold more money while determining • future needs. [2 pts: 1 pt for correct • graph and 1 pt for Dm shifting right.] r2 Nominal Interest Rate r1 Quantity of Money M Tutorial: These will shift the real Dm curve. 1. Changes in real aggregate spending, 2. Advances in banking technology. [ATMs available 24/7 decrease the need for cash (Dm)] 3. Changes in institutions [ability to get interest on checking accounts lead to an increase in Dm], 4. Riskiness of alternative stores of value [stocks]. Dm increases when stocks are appealing. • Answers for 1. (a) (ii) [1 point for saying the interest rate increases] • (a) (ii) The nominal interest rate would increase because the demand • for money increases as the DM curve shifts up, as shown above.

42. Let’s take a look at Banking History Then, we’ll look at the “Fed”.

43. Financial Reform Act - 1980 This act eliminated many historical distinctions between financial institutions. These once staid financial institutions moved into the fast lane. They could now “wheel and deal” with other peoples money but with the benefit of deposit insurance. Commercial Banks 7,600 Thrifts 11,400 Credit Unions 9,490 Savings and Loans 1,404 Mutual Savings Banks 387 Prior to 1980 Commercial banks issued checking accounts [others could not] & gave business loans [no interest allowed to be given on these checking accts]. Non Commercial Banks – accepted savings deposits[3%] and made mortgage loans [6%]. They started issuingNOW Accounts which paid about 5% if you kept $1,000 in. People were not writing checks, they were writing Negotiable Orders of Withdrawal. They may not have been called checking accts but they looked like checking accounts, sounded like checking accounts, smelled like checking accounts, and were evenrepresentedto customers as checking accounts.

44. Deregulation Act of 1980 1. All were now allowed to issueinterest-bearing checking deposits. [Commercial banks had been forbidden to pay interest on checking accounts,while thrifts claimed to be paying interest on savings accts] 2.S&Ls could give auto and real estate loans. 3. There was no limitation on interest rates paid. 4. Alldepository institutions were now subjectto theFed’s legal RR. 5. All now enjoyed the advantages that only Fed member banks formerly enjoyed-including check clearing & borrowing from the Fed The worst S&L scandal was Lincoln S&L in California under CharlesKeating ($3 billion horror story). Five senators [including John McCain] received $1.5 million in campaign contributions to influence regulators. Keating got 12 years in prison & had to pay $122 million although the government could never find any of his assets. This will cost around $300 billion – the worst financial mistake since the Great Depression. Charles Keating

45. S&L’s had been required by law to borrow short [savings deposits (3%)] and lend long[30-year fixed rate mortgages at 6%]. When this led to big losses in the inflation-racked early 80s, Congress encouraged thrifts to grow their way out of trouble, in part by financing commercial real estate, with disastrous results. They were now borrowing short giving savers 10% but still receiving only 6% on the long 30 year mortgages.

46. Federal Reserve - 1913 A. Boston B. New York C. Philly D. Cleveland E. Richland F. Atlanta G. Chicago H. St. Louis I. Minneapolis J. Kansas City K. Dallas L. San Francisco

47. 12 Fed Banks and 25 Branches 7th-G-Chicago (1) 8th-H-St. Louis (3) 9th-I-Minneapolis (1) 10th-J-Kansas City (3) 11th-K-Dallas (3) 12th-L-San Francisco (4) 1st-A-Boston (0) 2nd-B-New York (1) 3rd-C-Philadelphia (0) 4th-D-Cleveland (2) 5th-E-Richmond (2) 6th-F-Atlanta (5)

48. The Fed’s 25 Branches Fed Quasi-Public Banks.[in combo] Blend of [private ownership(corporations)but public (government)control] The 12 banks are instruments of the government but not owned by the government. The over5,000 banksin the 12 districts buy stock ($1per share)in their district bank (& get 6% dividends[no capital gains]) so the banks are privately owned. Serving the public, it isowned by citizens. The 12 banks are a corporation owned by the banks in their districts, but a public (G) agencydirectly responsible to Congress. They might make $30 billion - 90% to Treasury.

49. Four Part Structure of the Fed Seven Board of Governors • most important body of the Fed • appointed by the Presidentand confirmed by the Senate • 14-year terms are staggered (one replaced each two years) [they arepaid $162,100] • isolationfrom political pressure (only one 14 year term) • the Chairmanserves onlyfour years but can be reappointed [4-year renewable term] 4 times • His pay is $180,100. • Every presidentgets to appoint at least two. Clintonappointed 8 & Bush appointed 4in 1st 2 years. • One term begins every 2 years on Feb. 1 of even numbered years.

50. Kevin Warsh Unexpired term to 1/31/18 Donald Kohn Vice Chairman to 1/31/16 Ben Bernanke, Chairmanto 1/31/10 [1590 on SAT] Elizabeth Duke Unexpired to 1/31/12 Randall Kroszner Unexpired to 1/31/08 Frederic Mishkin Unexpired to 1/31/14 Vacant www.federalreserve.gov/BIOS/