cfo10e_ch10macro

7/28/2019 CFO10e_ch10macro

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RTIIITheCoreofMacroec

onomicTheory

2012 Pearson Education, Inc. Publishing as Prentice Hall

Prepared by: Fernando Quijano & Shelly TefftCASE FAIR OSTER

P R I N C I P L E S O F

MACROECONOMICST E N T H E D I T I O N


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CHAPTER OUTLINE

10The Money Supplyand the FederalReserve System

An Overview of Money

What Is Money?

Commodity and Fiat Monies

Measuring the Supply of Money in the United States

The Private Banking SystemHow Banks Create Money

A Historical Perspective: Goldsmiths

The Modern Banking System

The Creation of Money

The Money Multiplier

The Federal Reserve System

Functions of the Federal Reserve

Expanded Fed Activities Beginning in 2008

The Federal Reserve Balance Sheet

How the Federal Reserve Controls the Money Supply

The Required Reserve Ratio

The Discount Rate

Open Market Operations

Excess Reserves and the Supply Curve for Money

Looking Ahead


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onomicTheory


Money is a means of payment, a store of value, and a unit of account.

barter The direct exchange of goods and services for othergoods and services.

medium of exchange, or means of payment What sellersgenerally accept and buyers generally use to pay for goods

and services.


What Is Money?

A Means of Payment, or Medium of Exchange


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store of valueAn asset that can be used to transportpurchasing power from one time period to another.

liquidity property of money The property of money thatmakes it a good medium of exchange as well as a store ofvalue: It is portable and readily accepted and thus easilyexchanged for goods.

unit of account A standard unit that provides a consistentway of quoting prices.


What Is Money?

A Store of Value

A Unit of Account


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commodity monies Items used as money that also have intrinsicvalue in some other use.

fiat, or token, money Items designated as money that are

intrinsically worthless.

legal tender Money that a government has required to be acceptedin settlement of debts.

currency debasement The decrease in the value of money thatoccurs when its supply is increased rapidly.


Commodity and Fiat Monies


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In most countries commodity monies are notused anymore, but the world is a big placeand there are exceptions.

In the Solomon Islands, dolphin teeth arebeing used as a means of payment and a

store of value.

Note that even with a currency like dolphinteeth there is a concern about counterfeitcurrency, namely fruit-bat teeth, but alsotooth decay.

Dolphin Teeth as Currency

E C O N O M I C S I N P R A C T I C E

Shrinking Dollar Meets Its Match in Dolphin Teeth

Wall Street J ournal


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M1, or transactions money Money that can be directlyused for transactions.

M1 currency held outside banks + demand deposits +travelers checks + other checkable deposits



M1: Transactions Money


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near monies Close substitutes for transactions money, suchas savings accounts and money market accounts.

M2, or broad money M1 plus savings accounts, moneymarket accounts, and other near monies.

M2 M1 + savings accounts + money market accounts +other near monies



M2: Broad Money


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There are no rules for deciding what is and is not money.

This poses problems for economists and those in charge ofeconomic policy.



Beyond M2


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financial intermediaries Banks and other institutions that act as alink between those who have money to lend and those who want toborrow money.


The Private Banking System

The main types of financial intermediaries are commercial banks,followed by savings and loan associations, life insurance companies,and pension funds.


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run on a bank Occurs when many of those who have claims on abank (deposits) present them at the same time.

How Banks Create Money

A Historical Perspective: Goldsmiths

Todays bankers differ from goldsmithstodays banks are subject to

a required reserve ratio.

Goldsmiths had no legal reserve requirements, although the amountthey loaned out was subject to the restriction imposed on them bytheir fear of running out of gold.


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Assets Liabilities Net Worth

or

Assets Liabilities + Net Worth

Federal Reserve Bank (the Fed) The central bank of theUnited States.



A Brief Review of Accounting

reserves The deposits that a bank has at the FederalReserve bank plus its cash on hand.

required reserve ratio The percentage of its total depositsthat a bank must keep as reserves at the Federal Reserve.


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The balance sheet of a bank must always balance, so that the sum of assets (reserves andloans) equals the sum of liabilities (deposits and net worth).

FIGURE 10.1 T-Account for a Typical Bank (millions of dollars)



A Brief Review of Accounting


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excess reserves The difference between a banks actual reservesand its required reserves.

excess reserves actual reserves required reserves

In panel 2, there is an initial deposit of $100.

In panel 3, the bank has made loans of $400.

FIGURE 10.2 Balance Sheets of a Bank in a Single-Bank Economy




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In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 bycreating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) anddeposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on.

In the end, loans of $400 have been made and the total level of deposits is $500.

FIGURE 10.3 The Creation of Money When There Are Many Banks




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FIGURE 10.4 The Structure of the Federal Reserve System



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Federal Open Market Committee (FOMC)A group composed of the sevenmembers of the Feds Board of Governors, the president of the New York

Federal Reserve Bank, and four of the other 11 district bank presidents on arotating basis; it sets goals concerning the money supply and interest ratesand directs the operation of the Open Market Desk in New York.

Open Market Desk The office in the New York Federal Reserve Bank fromwhich government securities are bought and sold by the Fed.



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From a macroeconomic point of view, the Feds crucial role is to

control the money supply.

The Fed also performs several important functions for banks, such asclearing interbank payments, regulating the banking system, and

assisting banks in a difficult financial position.

The Fed is also responsible for managing exchange rates and thenations foreign exchange reserves.

It is often involved in intercountry negotiations on internationaleconomic issues.

lender of last resort One of the functions of the Fed: It providesfunds to troubled banks that cannot find any other sources of funds.


Functions of the Federal Reserve


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Expanded Fed Activities Beginning in 2008

When housing prices began to fall in late 2005, the stage was set for aworldwide financial crisis, which essentially began in 2008.

There has been much political discussion of whether the Fed should

have regulated more in 20032005 and whether it should beintervening in the private sector as much as it has been doing.

It is certainly the case that the Fed has taken a much more active rolein financial markets since 2008.


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TABLE 10.1 Assets and Liabilities of the Federal Reserve System, June 30, 2010(Billions of Dollars)

Assets Liabilities

Gold $ 11 $ 945 Currency in circulation

U.S. Treasury securities 777 970 Reserve balances

Federal agency debt securities 165 288 U.S. Treasury deposits

Mortgage-backed securities 1,118 170 All other liabilities and net worth

All other assets 302 $2,373 Total

Total $2,373


The Federal Reserve Balance Sheet


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If the Fed wants to increase the supply of money, it creates more reserves,thereby freeing banks to create additional deposits by making more loans. If itwants to decrease the money supply, it reduces reserves.

Three tools are available to the Fed for changing the money supply:

(1) Changing the required reserve ratio.

(2) Changing the discount rate.

(3) Engaging in open market operations.



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TABLE 10.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 PercentIncreases the Supply of Money (All Figures in Billions of Dollars)

Panel 1: Required Reserve Ratio = 20%

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

Panel 2: Required Reserve Ratio = 12.5%



Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans(+ $300)

$700 (+ $300)

Note: Money supply (M1) = currency + deposits = $900.




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Decreases in the required reserve ratio allow banks to have moredeposits with the existing volume of reserves.

As banks create more deposits by making loans, the supply of money(currency + deposits) increases.

The reverse is also true: If the Fed wants to restrict the supply ofmoney, it can raise the required reserve ratio, in which case banks willfind that they have insufficient reserves and must therefore reducetheir deposits by calling in some of their loans.

The result is a decrease in the money supply.




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discount rate The interest rate that banks payto the Fed to borrow from it.


The Discount Rate

moral suasion The pressure that in the past the

Fed exerted on member banks to discouragethem from borrowing heavily from the Fed.


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TABLE 10.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (AllFigures in Billions of Dollars)

Panel 1: No Commercial Bank Borrowing from the Fed



Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320


Panel 2: Commercial Bank Borrowing $20 from the Fed



Securities $160 $100 Reserves(+ $20)

Reserves(+ $20)

$100 $500 Deposits(+ $300)

Loans $20 $80 Currency Loans(+ $100)

$420 $20 Amount owed toFed (+ $20)



The Discount Rate


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open market operations The purchase and sale bythe Fed of government securities in the open market;a tool used to expand or contract the amount ofreserves in the system and thus the money supply.



The Treasury Department is responsible for collecting taxesand paying the federal governments bills.

The Fed is not the Treasury. It is a quasi-independent agencyauthorized by Congress to buy and sell outstanding(preexisting) U.S. government securities on the open market.

Two Branches of Government Deal in Government Securities


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TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show theDifferences between Those Panels and Panel 1. All Figures in Billions of Dollars)

Panel 1Federal Reserve Commercial Banks Jane Q. Public

Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts$80 Currency Loans $80 $5 Net Worth



Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities(- $5)

$95 $15 Reserves(- $5)

Reserves(- $5)

$15 $95 Deposits(- $5)

Deposits(-$5)

$0 $0 Debts

$80 Currency Loans $80 Securities(+ $5) $5 $5 Net Worth



Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities(- $5)

$95 $15 Reserves(- $5)

Reserves(- $5)

$15 $75 Deposits(- $25)

Deposits(- $5)

$0 $0 Debts

$80 Currency Loans(- $20)

$60 Securities(+ $5)

$5 $5 Net Worth




The Mechanics of Open Market Operations


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An open marketpurchase of securities by the Fedresults in an increase in reserves and an increasein the supply of money by an amount equal to themoney multiplier times the change in reserves.

An open market sale of securities by the Fedresults in a decrease in reserves and a decreasein the supply of money by an amount equal to themoney multiplier times the change in reserves.

We can sum up the effect of these open market operationsthis way:



The Mechanics of Open Market Operations


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If the Feds money supply behavior is not influenced by the interest rate, the money supply curveis a vertical line.

Through its three tools, the Fed is assumed to have the money supply be whatever value it wants.

FIGURE 10.5 The Supply of Money


Excess Reserves and the Supply Curve for Money


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Looking Ahead

This chapter has discussed only the supply side of the money market.

In the next chapter, we turn to the demand side of the money market.

We will examine the demand for money and see how the supply of anddemand for money determine the equilibrium interest rate.

S C O C S


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barter

commodity monies

currency debasement

discount rate

excess reserves

Federal Open Market Committee (FOMC)

Federal Reserve Bank (the Fed)

fiat, ortoken, money

financial intermediaries

legal tender

lender of last resort

liquidity property of moneyM1, ortransactions money

M2, orbroad money

medium of exchange, ormeans of payment

money multiplier

moral suasion

near monies

Open Market Desk

open market operations

required reserve ratio

reserves

run on a bank

store of value

unit of account

1. M1 currency held outside banks +

demand deposits + travelers checks +

other checkable deposits

2. M2 M1 + savings accounts + moneymarket accounts + other near monies

3. Assets Liabilities + Net Worth

4. Excess reserves actual reserves required reserves

5 Money multiplier ratioreser ereq ired

1

R E V I E W T E R M S A N D C O N C E P T S

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