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Money, Prices, and the Federal Reserve

Introduction. MoneyAny asset that can be used in making purchasesExamplesCurrencyCoinsChecks. Money and Its Uses. BarterThe direct trade of goods or services for other goods or services. Money and Its Uses. Medium of ExchangeAn asset used in purchasing goods and servicesUnit of AccountA basic measure of economic valueStore of ValueAn asset that serves as a means of holding wealth.

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Money, Prices, and the Federal Reserve

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    2. Introduction Money Any asset that can be used in making purchases Examples Currency Coins Checks

    3. Money and Its Uses Barter The direct trade of goods or services for other goods or services

    4. Money and Its Uses Medium of Exchange An asset used in purchasing goods and services Unit of Account A basic measure of economic value Store of Value An asset that serves as a means of holding wealth

    5. Money and Its Uses M1 Sum of currency outstanding and balances held in checking accounts M2 All the assets in M1 plus some additional assets that are usable in making payments but at greater cost or inconvenience than currency or checks

    6. Components of M1 and M2, April 2005 (billions of dollars)

    7. Commercial Banks and the Creation of Money Assume Republic of Gorgonzola No banking system Government issues 1 million guilders People want to place their 1 million guilders in a bank

    8. Consolidated Balance Sheet of Gorgonzolan Commercial Banks (Initial)

    9. Commercial Banks and the Creation of Money Bank Reserves Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments 100 Percent Reserve Banking A situation in which banks’ reserves equal 100 percent of their deposits

    10. Consolidated Balance Sheet of Gorgonzolan Commercial Banks After One Round of Loans

    11. Consolidated Balance Sheet of Gorgonzolan Commercial Banks after Guilders Are Redeposited

    12. Consolidated Balance Sheet of Gorgonizolan Commercial Banks After Two Rounds of Loans and Redeposits

    13. Final Consolidated Balance Sheet of Gorgonzolan Commercial Banks

    14. Commercial Banks and the Creation of Money Observations The use of a fractional-reserve banking system allows the money supply to grow as a multiple of the reserves In Gorgonzola, with a 10% reserve-deposit ratio, 1 guilder in reserve can support 10 guilders in deposit.

    15. Commercial Banks and the Creation of Money Summary Bank reserves/bank deposits = desired reserve-deposit ratio Bank deposits = bank reserves/desired reserve-deposit ratio

    16. Commercial Banks and the Creation of Money The Money Supply with Both Currency and Deposits Gorgonzola residents choose to hold 500,000 guilders as currency Deposit 500,000 in the banks Reserve-deposit ratio = 10% Bank deposits = 500,000/.10 = 5,000,000

    17. Commercial Banks and the Creation of Money The Money Supply with Both Currency and Deposits Money supply = currency + bank deposits 5,500,000 = 500,000 + 5,000,000 The money supply is reduced by 4,500,000 guilders when the residents hold 500,000 guilders in currency

    18. Commercial Banks and the Creation of Money The Money Supply at Christmas Currency = 500 Bank reserves = 500 Reserve-deposit ratio = 0.20 Money supply = 500 + 500/.20 = 500 + 2,500 = 3,000

    19. Commercial Banks and the Creation of Money The Money Supply at Christmas If Xmas shoppers withdraw 100 Money supply = 600 + 400/.20 = 600 + 2,000 = 2,600

    20. Commercial Banks and the Creation of Money The Money Supply at Christmas Observation When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal.

    21. The Federal Reserve System Two Main Responsibilities Monetary policy Oversight and regulation of financial markets

    22. The Federal Reserve System The History and Structure of the Federal Reserve System Founded by the Federal Reserve Act of 1913 The primary mission of the Fed is to promote economic growth, low inflation, and stable financial markets.

    23. The Federal Reserve System The Structure 12 regional Federal Reserve banks Assess economic conditions in their regions to assist in national policymaking Provide service to the commercial banks in their districts

    24. The Federal Reserve System The Structure Board of Governors Seven governors Appointed by the president and confirmed by the Senate to 14 year staggered terms Chairman of the Board of Governors Selected by the president from the governors Serves a four year term

    25. The Federal Reserve System The Structure Federal Open Market Committee (FOMC) Members include: The seven Fed governors President of the New York Fed Four presidents, chosen on a rotating basis, from the remaining Federal Reserve Banks Determines monetary policy

    26. The Federal Reserve System Controlling the Money Supply: Open-Market Operations The primary function of the Fed is monetary policy. The Fed controls the money supply by changing the supply of bank reserves.

    27. The Federal Reserve System Controlling the Money Supply: Open-Market Operations Open-market operations are the most important method of changing the supply of bank reserves.

    28. The Federal Reserve System Increasing The Money Supply The Fed purchases government bonds from the public. The people deposit the funds they get from their sale of bonds to the Fed. The increase in deposits increase bank reserves.

    29. The Federal Reserve System Increasing The Money Supply The increase in reserves will lead to an expansion of the money supply as banks make more loans. Recall The change in the money supply is a multiple of the change in reserves.

    30. The Federal Reserve System Reducing The Money Supply The Fed sells government bonds to the public. The Fed presents the checks from the sale of the bonds to the banks for payment.

    31. The Federal Reserve System Reducing The Money Supply The bank’s reserves will fall when they clear the checks. The money supply will fall by a multiple of the decrease in reserves.

    32. The Federal Reserve System 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

    33. The Federal Reserve System 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

    34. The Federal Reserve System Open-Market Operations Open-market purchases and open-market sales

    35. The Federal Reserve System Example Increasing the money supply by open-market operations Currency = 1,000 shekels Reserves = 200 Reserve-deposit ratio = 0.2

    36. The Federal Reserve System Example Increasing the money supply by open-market operations Money supply = 1,000 + 200/0.2 = 2,000 shekels Open market purchase = 100 Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 shekels

    37. The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics Suppose: Depositors lose confidence in their bank. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to meet the depositors demand. The bank fails and further erodes depositor confidence which triggers additional failures.

    38. The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed to the rescue: Instill confidence Discount lending Open Market Operations

    39. The Federal Reserve System Economic Naturalist The banking panics of 1930 - 1933 and the money supply One-third of U.S. banks closed Depositors withdrew their funds Banks raised the reserve-deposit ratio

    40. Key U.S. Monetary Statistics, 1929-1933

    41. The Federal Reserve System Economic Naturalist In response to the panics of 1929-1933, deposit insurance was established in 1934. Deposit insurance gives depositors an incentive to keep their money in the banks. Deposit insurance reduces the incentive for depositors to pay attention to the financial strength of their bank.

    42. The Federal Reserve System What Do You Think? Why worry about the money supply?

    43. Money and Prices Velocity A measure of the speed at which money changes hands in transaction involving final goods and services

    44. Money and Prices Velocity A measure of the speed at which money changes hands in transaction involving final goods and services

    45. Money and Prices Velocity in 2004 M1 = $1,367.3 billion M2 = $6,428.4 billion Nominal GDP = $11,734.3 billion

    46. Money and Prices Money and Inflation in the Long Run Recall

    47. Money and Prices Money and Inflation in the Long Run Quantity equation M x V = P x Y Assume V & Y are constant over the time period

    48. Money and Prices Money and Inflation in the Long Run If the Fed increases M by 10%, then prices must increase by 10%. High rates of money growth are associated with high rates of inflation (too much money chasing too few goods).

    49. Money and Prices What Do You Think? If high rates of money growth lead to inflation, why do countries allow their money supplies to rise quickly?

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