The Monetary System

EQ: What is money?

Class Auction

• Want to have this piece of candy?• What are you willing to trade for it?• What is required for this trade (barter) to

work?• What is the solution for this “double

coincidence of wants?”

With a partner, answer this question - What is money?

What is Money?Money is the set of assets in an economy that people regularly use to buy goods and services from other people.

Types of Money

Commodity Money Fiat Money

What type of money does the U.S. use?

Functions of Money

• Medium of Exchange

Functions of Money

• Standard of Value

Functions of Money

• Store of Value

Summary

• Draw the 3 functions of money – do not label each function

• Then with a partner, switch papers and each partner tries to identify each picture

Durable Limited

Characteristics of Money

Portable Divisible

It is important that money is ___________ because………………………

Liquidity

• Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.

What is the most liquid asset?

What are some less liquid assets?

Money in the U.S. Economy

• Currency is the paper bills and coins in the hands of the public.

• Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

Figure 1 Two Measures of the Money Stock for the U.S. Economy

Billionsof Dollars

• Currency

($699 billion)

• Demand deposits• Traveler ’ s checks• Other checkable deposits ($664 billion)

• Everything in M1($1,363 billion)

• Savings deposits• Small time deposits• Money market mutual funds• A few minor categories ($5,035 billion)

0

M1$1,363

M2$6,398

CASE STUDY: Where Is All The Currency?

• In 2004 there was $699 billion of U.S. currency outstanding.– That is $3,134 in currency per adult.

• Who is holding all this currency?– Currency held abroad– Currency held by illegal entities

Review Video

What agency has authority to print currency in the U.S.?

The Federal Reserve System

• The Federal Reserve (Fed) serves as the nation’s central bank – created 1913.– It is designed to oversee the banking system.– It regulates the quantity of money in the economy

(monetary policy).– It is the lender of last resort.

The FED

• Privately Owned- banks buy stock in the Fed

like a corporation

• Board of Governors- 7 member board

appointed by the Fed. Set policies for the Fed

• Federal Reserve District Banks- Nation is

divided into 12 districts. Each district bank

runs a district and has a president and board

of directors

FED Chairman

Monetary Policy Tools

1. Federal Open Market Operations Committee (FOMC)

2. Reserve Requirement3. Discount Rate/Federal Funds Rate

*******FOMC******

• To increase the money supply, the Fed buys government bonds from the public.

• To decrease the money supply, the Fed sells government bonds to the public.

• The Fed uses OMO to control the Fed Funds rate (the rate banks charge each other for over night lending)What does an increase in the money supply do to the nominal interest rate and price levels? Decrease?

Reserve Requirement

• Reserves are deposits that banks have received but have not loaned out.

• In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

• The reserve ratio is the fraction of deposits that banks hold as reserves.

What is the risk with this type of banking?

Banking Money Creation with Fractional-Reserve

• This T-Account shows a bank that…– accepts deposits,– keeps a portion

as reserves, – and lends out

the rest. • It assumes a

reserve ratio of 10%.

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Owns Owes

T Accounts – assume 1/5 rr1. $1000 deposit into

checking2. Bank issues $5000 in

loans3. FED buys $1000 worth

of govt securities4. FED sells $1000 worth

of govt securities5. What is the money

multiplier?

Assets Liabilities

$2000 Required Reserves

$6000 Excess Reserves

$2000 Securities

$10000 Deposits

Money Creation… out of thin air…

Increase in the Money Supply = $190.00!

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00

Total Liabilities$90.00

The Money Multiplier

Original deposit = $100.00• 1st Natl. Lending = 90.00 (=.9 x $100.00)• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)• … and on until there are just pennies left to

lend!• Total money created by this $100.00 deposit is

$1000.00. (= 1/.1 x $100.00)

The Money Multiplier

• The money multiplier is the reciprocal of the reserve ratio:

M = 1/R• Example:– With a reserve requirement, R = 20% or .2:– The money multiplier is 1/.2 = 5.

1 – 5 on L4/A38 wksht

The Fed and the Reserve Requirement

• What does changing the reserve requirement from 10% to 20% do the money supply? Nominal interest rates? Show me the new multiplier.

• What does decreasing the reserve requirement do to the money supply? Nominal interest rates? Show me the new multiplier.

The Discount Rate (no longer used)

• The discount rate is the interest rate the Fed charges banks for loans.– Increasing the discount rate decreases the money

supply. – Decreasing the discount rate increases the money

supply.

Discount rate now set higher than FFR… why does this make the discount rate obsolete?

FED REVIEW

• http://www.youtube.com/watch?v=HdZnOQp4SmU

6-12 on L4/A38 wksht

finish remainder for HW

11/10 Warm up

• A-F on worksheet

Warm-up

• Scenario – high unemployment and low growth (show this on ASAD graph)1. Action by FED – loose or tight?2. OMO – Buy or sell bonds? Why?3. What happens to money supply (graph)? Why?4. What happens to nominal interest (same

graph)? Why?5. What happens to investment? Why?6. What happens to aggregate demand? Why?

EQ: How do interest rates affect the macroeconomy?

Watch the video to complete the chart

Demand Deposit

RR Money Multiplier

Excess Reserves available for loans

What is the max money created(not including original deposit)?

$20000 5%

$20000 10%

$20000 15%

Review Video – Creating Money

Watch the video to complete the chart

Demand Deposit

RR Money Multiplier

Excess Reserves available for loans

What is the max money created(not including original deposit)?

$20000 5%

$20000 10%

$20000 15%

What are some potential problems with controlling the money supply?• The Fed’s control of the money supply is not

precise.• The Fed must wrestle with two problems that

arise due to fractional-reserve banking.– The Fed does not control the amount of money

that households choose to hold as deposits in banks.

– The Fed does not control the amount of money that bankers choose to lend.

RR _____DR _____OMO – Buy or SellFF Target _____MS _____Excess Reserves _____Nom interest rate _____I_____AD ______

Monetary policy in action

Easy/Expansionary Policy Tight/Contractionary Policy

RR _____DR _____OMO – Buy or SellFF Target _____MS _____Excess Reserves _____Nominal interest rate_____I_____AD ______

↓ RR= Banks can loan more $Fed Buys OMO’s = bank have more $ fewer bonds↓Discount Rate= Fed lowers cost of borrowing*↓Federal Funds Rate Target = Fed lowers cost of bank borrowing and lending – done by OMO

↑RR = Banks have less $ to loan out.Fed Sells OMO’s = banks have less $ and more Bonds↑Discount Rate = Fed lowers cost of borrowing*↑Federal Funds Rate Target = Fed increases the cost of bank borrowing and lending – done by OMO

Monetary policy in actionEasy Money Tight Money

So…. How do monetary policies affect macroeconomic goals?

Whiteboards

Three L’s and Win:

MO

NE

TA

RY

PO

LIC

Y S

OL

UT

ION

GR

AP

H A

1

A

OMO buy MS r , r I , I AD

PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE)

(the decrease in r leads to an increase in the quantity of interest sensitive investment demanded)

B

discount rate MS r , r I , I AD

PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE)

(the decrease in r leads to an increase in the quantity of interest sensitive investment demanded)

C

RR MS r , r I , I AD

PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE)

(the decrease in r leads to an

increase in the quantity of interest sensitive investment demanded)

Draw a money market graph showing

expansionary monetary policy.

What happens to investment given

the change in interest rates?

Draw and AD/AS graph starting

with a recessionary gap.

What curve will shift? What will

happen to employment, output, and

prices?

MO

NE

TA

RY

PO

LIC

Y

SOL

UT

ION

GR

APH

C

2

A

OMO sale MS r , r I , I AD

PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE)

(the increase in r leads to a decrease in the quantity of interest sensitive investment demanded)

B

discount rate MS r , r I , I AD

PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE)

(the increase in r leads to a decrease in the quantity of interest sensitive investment demanded)

C

RR MS r , r I , I AD

PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) E (Y1-FE)

(the increase in r leads to a decrease in the quantity of interest sensitive investment demanded)

What happens to investment given

the change in interest rates?

Draw a money market graph

showing contractionary

monetary policy.

Draw and AD/AS graph starting

with a inflationary gap. What curve will shift? What will happen to employment, output, and

prices?

Review Video

So…. How do monetary policies affect macroeconomic goals?

• http://www.frbsf.org/education/activities/chairman/