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Ch. 9: Money, the Price Level, and Inflation. 9. Definition of money and its functions Economic functions of banks and other depository institutions Structure and function of the Federal Reserve System Creation of money by the banking system

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Ch. 9: Money, the Price Level,

and Inflation


  • Definition of money and its functions
  • Economic functions of banks and other depository institutions
  • Structure and function of the Federal Reserve System
  • Creation of money by the banking system
  • Demand for money, the supply of money, and the nominal interest rate
  • Link between quantity of money, the price level and inflation
what is money
What is Money?

Anything that is generally acceptable as a means of payment.

  • Commodity Money
    • gold dust, tobacco, cigarettes in POW camp
    • Problems: transactions cost; perishable; value fluctuates.
  • Coins with precious metal
    • Gold & silver coins
    • Problems:
      • Coin shaving; value of metal fluctuates.
      • Greshams Law: Bad money drives out good.
  • Fiat money
money in u s history
  • U.S. constitution gave Congress sole right to "coin money and regulate value thereof". Illegal for states to coin money.
  • Bi-metallic standard initially.
  • In the 1792 coin act, a $1 coin was quoted in terms of both silver and gold.
      • 24.75 grains of gold =$1
      • 371.25 grains of silver = $1
gresham s law
  • "bad money drives out good"
  • Prior to 1834, 24.75 grains of gold was worth more than 371.25 grains of silver. Only silver coins circulated (a "silver standard" by default).
  • After 1834, the reverse was true (a "gold standard" by default).
  • If gold coin has 10 grains and silver has 30 grains, what happens if gold price is 5 times silver price? 2 times silver price?
  • What happens to coin circulation if price of its metal rises relative to other metals?
  • Wizard of Oz and bimetallic standard
functions of money
Functions of Money

Medium of Exchange

  • Generally accepted in exchange for goods and services.
  • Without money, trade is barter system.
  • Barter requires a double coincidence of wants makes it costly.

Unit of Account

An agreed measure for stating the value of goods and services.

3 functions of money
3 Functions of Money

Store of Value

  • Money can be held for a time and later exchanged for goods and services.
  • Can be poor store of value
    • Inflation
    • No interest
history of banking
  • Initially banks formed as “safekeeping” institutions.
  • Gradually evolved to serve several functions:
      • Create liquidity
      • Minimize the cost of obtaining funds
      • Minimize the cost of monitoring borrowers
      • Pool risks
history of banking in u s
  • States could not print or mint money, but privately owned banks could if licensed by the state government.
  • Banks printed notes that were backed by gold or silver
      • easier to trade
      • avoided problems with weighing
      • banks found it profitable to print more notes than they had "reserves“ (gold/silver) for and loaned out the extra notes.
  • Fractional reserve banking was started.
  • Fractional reserve banking poses problems if there is a “bank run”.


  • Reserves (gold) 100 Notes 100
  • Total 100 100
  • Banks would print notes beyond reserves and extend loans.
  • Reserves 100 Notes 1000
  • Loans 900 ____
  • Total 1000 1000

With “fractional reserve banking”, the banking system

      • “creates money” and lends it out.
      • has only a fraction of liabilities on reserve.
      • cannot satisfy customer’s demands if all want to withdraw deposits at once.
  • Source of “bank panics”.
      • News that loans are not likely to be paid back, customers will make a “run” on the bank.
      • Droughts.
      • Stock market crash.
  • Effect of bank panic on economy?
bank panics and deposit insurance
Bank Panics and Deposit Insurance
  • 7 major bank panics in the U.S. in the 1800s
      • 2 in the early 1900s.
      • Onset of the great depression in the 1930s, another bank panic occurred.
      • In 1934, the federal government established FDIC to help reduce spread of bank panics.
  • Deposit insurance has reduced bank panics in the U.S.
  • Problems with deposit insurance
      • Incentives created for risk taking.
      • The Home State experience in Ohio.
bank objectives
Bank Objectives.

Profit vs. Prudence: A Balancing Act

Goal of any bank is to maximize wealth of its owners.

To accomplish this, must consider:

  • Attracting deposits to make loans possible.
  • Choosing loan portfolio and balance risk versus return.
  • Liquidity.
  • Service quality, fees, etc.
bank objectives13
Bank Objectives.

Risk, Return, and Liquidity.

  • Liquid assets (low risk, low return)

U.S. government Treasury bills and commercial bills

2. Investment securities

longer–term U.S. government bonds and other bonds

3. Loans (higher risk, higher return)

commitments of fixed amounts of money for agreed-upon periods of time

federal reserve system
Federal Reserve System
  • established in 1913 by the Federal Reserve Act.
  • first central bank of the United States
  • conducts monetary policy and regulates banks.
  • aims to stabilize the macroneconomy.
the federal reserve system
The Federal Reserve System

The Structure of the Fed

The key elements in the structure of the Fed are

  • The Board of Governors
  • The regional Federal Reserve banks
  • The Federal Open Market Committee
the federal reserve system16
The Federal Reserve System

Board of Governors

  • 7 members appointed by the president and confirmed by Senate.
  • Terms are for 14 years
  • The president appoints one member to a four-year term as chairman.

Regional Banks

  • Each of the 12 Federal Reserve Regional Banks has a nine-person board of directors and a president.
  • Monitors economic conditions within district and regulates banks
  • Clearinghouse for checks and replacement of currency
the federal reserve system18
The Federal Reserve System

Federal Open Market Committee

  • FOMC is the main policy-making group in the Federal Reserve System.
  • Consists of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the 11 presidents of other regional Federal Reserve banks of whom, on a rotating basis, 4 are voting members.
  • The FOMC meets every six weeks to formulate monetary policy.
components of the money supply
Components of the Money Supply

Bank reserves bank deposits at the Federal Reserve + cash

Monetary base currency held by the nonbank public + bank reserves.

M1 currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses.

M2 M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.

how do banks create money
How do banks create money?
  • Suppose that there is $100 million of cash and no bank system.
  • A bank now begins and $90 million of cash is deposited in the bank in exchange for checking account (demand deposit) balances.
  • The bank’s owners invest $5 million in plant and equipment and thus have $5 million of owner’s equity. The bank’s balance sheet is now:
how do banks create money22
How do banks create money?

Note: The balance sheet requires that total assets equal total liabilities.

how do banks create money23
How do banks create money?
  • Fed sets a reserve ratio (let’s suppose it’s 25%). Implying bank must have 25% of it’s demand deposits on reserve.
  • Reserves = cash in bank + deposits at Fed.
  • Bank can increase demand deposits by creating new loans to customers until it no longer has any excess reserves.
  • required reserves = rr * demanddeposits
  • Maximum demand deposits = (1/rr) * reserves
how do banks create money24
How do banks create money?

Note: The bank system created $270 million of additional money by creating new demand deposits for borrowers (loans). This assumes that none of the new loans/demand deposits are withdrawn as cash.

how banks create money
How Banks Create Money
  • Deposits lead to a multiplier effect on M1 as banks convert a $1 deposit into several dollars of demand deposits.
  • To illustrate, assume rr=25%
      • A new deposit of $100,000 is made.
      • The bank keeps $25,000 in reserve and lends $75,000.
      • This loan is credited to someone’s bank deposit.
      • The person spends the deposit and another bank now has $75,000 of extra deposits.
      • This bank keeps $18,750 on reserve and lends $56,250.
how banks create money26
How Banks Create Money
  • The process continues and keeps repeating with smaller and smaller loans at each “round.”
how do banks create money27
How do banks create money?

Summary of money creation process.

monetary base = nonbank cash + bank reserves

M1 = nonbank cash + demand dep.

DDmax = (1/rr) * bank reserves

The Fed controls the money supply through its control over the monetary base and the deposit multiplier (1/rr).

fed tools
Fed Tools

Open market operations.

  • The Fed buys (sells) government securities in the open market to increase (decrease) the money supply.

Discount window lending.

  • The Fed loans reserves to member banks and charges the discount rate.

Reserve requirements.

  • The Fed sets the required reserve ratio.
  • Rarely used.
open market operations
  • If the Fed wants to increase the amount of bank reserves
      • buy government securities from member banks
      • banks give up government bonds and receive deposit at the Fed or cash.
  • By buying government securities
      • Fed created new reserves that multiply into new loans and demand deposits (remember the deposit multiplier).
  • If the Fed sold government securities, reserves and M1 would decrease.
changes in the money supply
Changes in the money supply

Suppose the Fed purchases $10 m. of government securities. What is the effect on:

Loans Demand deposits M1

discount window lending
  • The Fed lends banks reserves at the “discount rate”.
      • The higher the discount rate, the less likely banks are to borrow reserves to increase the money supply.
  • The federal funds rate is the interest rate that banks charge each other for a loan of reserves.
      • The federal funds rate tracks the discount rate fairly closely.
  • If the Fed wants to increase reserves in the sytem, it would lower the discount rate.
the reserve requirement
  • If the Fed increases the reserve requirement
      • the deposit multiplier (1/rr) falls
      • the amount of demand deposits that banks can create for a given amount of reserves is reduced.
      • [Note: you may ignore the “money multiplier” discussed in text. Focus only on “deposit multiplier”]
changes in the money supply34
Changes in the money supply

Suppose the Fed reduces the rr to 20% What is the effect on:

Loans Demand deposits M1

other factors influencing the money supply
  • The amount of cash people choose to hold
      • Cash in bank multiplies
      • Cash outside bank does not.
  • The type of deposits people make.
      • the reserve requirement is higher on demand deposits (about 3%) than on certificates of deposit.
      • If people switch between different types of accounts, the “average” reserve requirement and money multiplier will change.
changes in the money supply36
Changes in the money supply

Suppose the public withdraws $10m. Of DD as cash. What is the effect on:

Loans Demand deposits M1

the market for money
The Market for Money

The Demand for Money Holding

The quantity of money that people plan to hold depends on four main factors:

  • The price level
  • The nominal interest rate
  • Real GDP
  • Financial innovation
the market for money38
The Market for Money

The Price Level

An increase in the price level

  • increases the quantity of nominal money people wish to hold
  • doesn’t change the quantity of real money that people plan to hold.
  • Real money equals nominal money ÷ price level.
  • 10 percent increase in P increases the quantity of nominal money demanded by 10 percent.
the market for money39
The Market for Money

The Nominal Interest Rate

the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset.

Increase in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.

Real GDP

An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.

the market for money40
The Market for Money

Financial Innovation

that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold.

The Demand for Money

is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same.

the market for money42
The Market for Money

Short-Run Equilibrium

Suppose that the Fed’s interest rate target is 5 percent a year.

The Fed adjusts the quantity of money each day to hit its interest rate target.

the market for money44
The Market for Money

Long-Run Equilibrium

In the long run, the loanable funds market determines the interest rate.

Nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate.

Real GDP equals potential GDP, so the only variable left to adjust in the long run is the price level.

the quantity theory of money
The Quantity Theory of Money

The quantity theory of money is the proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

The quantity theory of money is based on the velocity of circulation and the equation of exchange.

The velocity of circulation is the average number of times in a year a dollar is used to purchase goods and services in GDP.

the quantity theory of money46
The Quantity Theory of Money

V=velocityP=price levelY=real GDPM=quantity of money

The equation of exchangestates that

MV = PY.

The equation of exchange becomes the quantity theory of money if M does not influence V or Y.

% change in P = % change in M

the quantity theory of money47
The Quantity Theory of Money

Expressing the equation of exchange in growth rates:

 % ch in M + % ch in V = % ch in P + % ch in Y % ch in P = % ch in M + % ch in V - % ch in Y

In the long run, velocity does not change, so

Inflation rate = Money growth rate  Real GDP growth

the quantity theory of money49
The Quantity Theory of Money

International evidence shows a marked tendency for high money growth rates to be associated with high inflation rates.

evidence for 134 countries from 1990 to 2005.