ch11 all macro__lecture_ppt

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Chapter 11 The Monetary

System


11 The Monetary System

Chapter Outline

11.1 Money

11.2 Money, Prices, and GDP

11.3 Inflation

EBE What caused the German hyperinflation of 1922‒1923?

11.4 The Federal Reserve



Key Ideas

1. Money has three key roles: serving as a medium of exchange, a store of value, and a unit of account.

2. The quantity theory of money describes the relationship between the money supply, velocity, prices, and real GDP.



Key Ideas

3. The quantity theory of money predicts that the inflation rate will equal the growth rate of the money supply minus the growth rate of real GDP.

4. The Federal Reserve, the U.S. central bank, has a dual mandate—low inflation and maximum employment.



Key Ideas

5. The Federal Reserve holds the reserves of private banks.

6. The Federal Reserve’s management of private bank reserves enables the Fed to do three things: (1) set a key short-term interest rate; (2) influence the money supply and the inflation rate, and (3) influence long-term real interest rates.


11.1 Money

Money is an asset that people use to make and receive payments when buying and selling goods and services.


11.1 Money

Money serves three functions in a modern economy:

1. It is a medium of exchange.2. It is a store of value.3. It is a unit of account (measure of worth).


11.1 Money

A medium of exchange is an asset that can be traded for goods and services.


11.1 Money

A store of value is an asset that enables people to transfer purchasing power into the future.


11.1 Money

A unit of account is a universal yardstick that is used to express relative prices of goods and services.


11.1 Money

Question: What function(s) does each item fulfill?

Item

Function

Medium of Exchange

Store of Value

Unit of Account

Sea shellGold coin

CowU.S. dollar

Bitcoin


11.1 Money

Answer:

Item

FunctionMedium of Exchange

Store of Value

Unit of Account

Sea shell YES NO YESGold coin YES YES YES

Cow YES YES NOU.S. dollar YES YES YES

Bitcoin YES YES YES


11.1 Money

The U.S. dollar and other national currencies are examples of fiat money.

Fiat money An asset that is used as legal tender by government decree and is not backed by a physical commodity like gold.


11.1 Money

The money supply (M2) is the sum of currency in circulation, checking accounts, savings accounts, and most other types of bank accounts.


Currency in circulation11%

Checking accounts14%

Savings accounts65%

Time deposits5%

Money market accounts5%

Traveler's checks0.03%

11.1 Money


We can divide each monetary measure by GDP:

11.1 Money


11.1 Money

Exhibit 11.1 Currency in Circulation Divided by Nominal GDP and Money Supply (M2) Divided by Nominal GDP



Let’s remember a few definitions from Chapter 5:

• Nominal GDP is the total value of production (final goods and services), using the prices from the same year the output was produced.

• Real GDP is the total value of production (final goods and services), using fixed prices taken from a particular base year (which may or may not be the year the output was produced).



Consider the Island of Dr. Jay, which produces only basketballs.

Calculate nominal and real GDP for the base year of 2013:

Year

BasketballsNominal

GDP Real GDPNumber Price2013 10 $802014



Suppose that nominal GDP increases to $1,000 in 2014, but the source of the increase is unknown:

We will consider two possible scenarios.

Year

BasketballsNominal

GDP Real GDPNumber Price2013 10 $80 $800 $8002014 ?? ?? $1,000 ??



Scenario A:

Calculate the level of real GDP in 2014.

Calculate the growth rate of real GDP.

Calculate the growth rate of prices.

Year

BasketballsNominal

GDPRealGDPNumber Price

2013 20 $40 $800 $8002014 25 $40 $1,000



Scenario A:

The growth rate of real GDP is

The growth rate of prices is

Year

BasketballsNominal


2013 20 $40 $800 $8002014 25 $40 $1,000 $1,000

$0 = 0.00$40

$1000 $800 = 0.25

$800



Scenario B:

Calculate the level of real GDP in 2014.

Calculate the growth rate of real GDP.

Calculate the growth rate of prices.

Year

BasketballsNominal


2013 20 $40 $800 $8002014 20 $50 $1,000



Scenario B:

The growth rate of real GDP is

The growth rate of prices is

Year

BasketballsNominal


2013 20 $40 $800 $8002014 20 $50 $1,000 $800

$50 $40 = 0.25

$40

$800 $800 = 0.00

$800



Here is a summary of our results:

Scenario

Growth Rate of Nominal

GDP

Growth Rate of

Real GDPGrowth Rate

of PricesA 25% 25% 0%B 25% 0% 25%


Under each scenario, we found that:

Growth rate of nominal GDP = Growth rate of real GDP + Growth rate of prices

Growth rate of nominal GDP = Growth rate of real GDP + Inflation rate



The quantity theory of money assumes that the ratio of money to GDP is constant:

A constant ratio is a good approximation of how an economy behaves in the long run.

Money Supply = constant

Nominal GDP




Exhibit 11.1 Currency in Circulation Divided by Nominal GDP and Money Supply (M2) Divided by Nominal GDP


A constant ratio implies that money and nominal GDP must grow at the same rate:

Growth rate of money supply = Growth rate of nominal GDP

Using our previous relationship, we get:

Growth rate of money supply = Inflation rate + Growth rate of real GDP



Rearranging terms, the quantity theory predicts the rate of inflation:

Inflation rate = Growth rate of money supply – Growth rate of real GDP



11.3 Inflation

Some distinctions:

Inflation A situation of rising prices.

Deflation A situation of falling prices (negative inflation).

HyperinflationA situation of extreme inflation where prices double

within three years.


11.3 Inflation

Question: What causes inflation?

Data: Average money growth and inflation rates for 2000‒2010 for 179 countries (World Development Indicators).

Prediction: Inflation rate = Growth rate of money supply – 3%

0 500 1,000 1,500 2,000 2,500 3,000 3,5000

500

1,000

1,500

2,000

2,500

3,000

3,500

Money Growth and Inflation (179 countries)

Average money growth (%)

Ave

rage

infl

atio

n r

ate

(%)

Zimbabwe

11.3 Inflation


11.3 Inflation

0 10 20 30 40 50 60 70 80 90 100 1100

10

20

30

40

50

60

70

80

90

100

110

Money Growth and Inflation (178 countries)

Average money growth (%)

Ave

rage

infl

atio

n r

ate

(%)

Democratic Republic of Congo

Angola

Guinea

Belarus

Serbia

Tajikistan

Venezuela

Japan



Under inflation, all prices and all wages do not always move together.

Under inflation, some relative prices, includingthe real wage and real interest rate, can change.

This creates winners who benefit from unexpected gains and losers who suffer from unexpected losses.

11.3 Inflation


Who wins and who loses from unexpected inflation?

Winners:

1. A homeowner paying a mortgage at a fixed rate of interest

2. The owners of a firm (shareholders) paying a pension that is not indexed for inflation

11.3 Inflation


Losers:

1. A bank receiving payments on a mortgage at a fixed rate of interest

2. A retiree receiving a pension that is not indexed for inflation

11.3 Inflation


Inflation imposes social costs due to:

1. Raising logistical costs2. Distorting relative prices

Inflation can lead to counterproductive policies such as price controls.

11.3 Inflation


Inflation generates social benefits such as:

1. Generating government revenue from printing currency

2. Sometimes stimulating economic activity

11.3 Inflation


Evidence-Based Economics Example:

Question: What caused theGerman hyperinflation of 1922‒1923?

Data: Historical money supply data.



Historical Timeline:

• 1919: Germany signs the Treaty of Versailles, thus ending World War I.

• 1923: German workers in the Ruhr go on strike to protest the French occupation.

• November 1923: Hitler attempts to overthrow the government in the Beer Hall Putsch.

• 1933: Hitler is elected chancellor of Germany.




Exhibit 11.3 Currency in Circulation During the Weimar Republic


Evidence-Based Economics Example:

Question: What caused the German hyperinflation of 1922–1923?

Answer: The German government could not make reparation payments to the Allies after World War I. As the German economy struggled, the government started to print more and more currency to pay its bills.



The central bank is the government institution that: • Monitors financial institutions• Controls certain key interest rates• Indirectly controls the money supply

These activities are known as monetary policy.



The Federal Reserve Bank, or the Fed, is the central bank of the United States.



The Fed is composed of three parts:

• Twelve Federal Reserve district banks throughout the country

• A 7-member Board of Governors in Washington D.C.

• A 12-member Federal Open Market Committee, composed of 5 regional bank presidents and the 7 board members




Exhibit 11.4 Geographic Boundaries of the Federal Reserve Districts


The Fed uses monetary policy to pursue two key goals or objectives:

1. Low and predictable levels of inflation

2. Maximum (sustainable) levels of employment



What does the central bank do?

• Influences short-term interest rates, especially the federal funds rate

• Influences the money supply and the inflation rate

• Influences long-term real interest rates



To understand these three objectives, we will discuss the following, in order:

1. The role of bank reserves in the economy

2. The equilibrium in the market for bank reserves

3. The Fed’s influence on the money supply and inflation

4. The impact of short-term interest rates on long-term interest rates



Bank reserves are the combination of deposits that private banks hold at the central bank and cash in their vaults.

Bank reserves provide liquidity to private banks.

Liquidity refers to funds (and assets) that can be used immediately to conduct transactions.



Federal funds market The market where banks borrow and lend reserves to one another.

Federal funds rateThe overnight (24-hour) interest rate charged in this market.

We will use the supply and demand model to see how the federal funds rate is determined.




The demand curve for reserves plots the total quantity of reserves demanded by private banks for each level of the federal funds rate.

The demand curve slopes downward because optimizing banks choose to hold more reserves as the cost of those reserves—the federal funds rate—falls.



Exhibit 11.5 The Demand Curve in the Federal Funds Market (demand curve for reserves only)



The demand curve for bank reserves shifts when one of the following changes occurs:

1. Economic expansion or contraction

2. Changing liquidity needs

3. Changing deposit base

4. Changing reserve requirement

5. Changing interest paid by the Fed for deposits at the Fed



Example: The Christmas holiday increases withdrawals and thus the liquidity needs of banks.

Question: What would happen to the demand curve in the federal funds market?



Exhibit 11.5 The Demand Curve in the Federal Funds Market (demand curve for reserves and right shift in the demand curve)



Exhibit 11.5 The Demand Curve in the Federal Funds Market (demand curve for reserves and left shift in the demand curve)



Situation: An economic contraction decreases bank lending.

Question: What would happen to the demand curve in the federal funds market?



The supply curve for reserves plots the quantity of reserves supplied by the Federal Reserve through open market operations.



In an open market purchase, the Fed buys government bonds from private banks and in return gives the private banks more reserves.

In an open market sale, the Fed sells government bonds to private banks, and in return the private banks give some of their reserves.



The supply curve for reserves plots the quantity of reserves supplied by the Federal Reserve through open market operations.

The supply curve is vertical because the Federal Reserve supplies reserves not to earn economic profits but rather to pursue monetary policy.



The Federal Reserve chooses between two alternative strategies when it implements monetary policy:

1. The Federal Reserve can keep reserves fixed, even when the demand curve shifts, and thus allow the federal funds rate to fluctuate.



Exhibit 11.6 Equilibrium in the Federal Funds Market



2. The Federal Reserve can supply more or less reserves to keep the federal funds rate constant.



Exhibit 11.8 Picking Reserves to Keep the Federal Funds Rate Fixed



The Federal Reserve can control either the quantity of reserves or the federal funds rate (the price) but not both.

The Fed has followed the second strategy for the past 30 years.



However, the Fed will periodically raise and lower its federal funds target in order to meet its dual objectives of low inflation and maximum employment.



Exhibit 11.9 Shifts in the Federal Funds Rate Induced by a Shift in theSupply of Reserves



Exhibit 11.10 The Federal Funds Rate Between July 1954 and January 2014



Summary of the Fed’s Control of the Federal Funds Rate:

The Fed can influence the federal funds rate by either shifting the quantity of reserves supplied or by shifting the demand for reserves.



Summary of the Fed’s Control of the Federal Funds Rate:

The Fed can shift the demand of reserves by changing the reserve requirement and by changing interest paid on reserves.

The Fed can shift the supply curve of reserves through open market operations.



We said earlier that the second part of the Fed’s management of bank reserves is to influence the money supply and the inflation rate.

Question: Why can’t the Fed directly control either the money supply or the inflation rate?



Answer: The money supply is the sum of currency in circulation plus deposits at banks by households and firms. It does not include bank reserves.

In the long run, inflation is equal to the growth rate of money.



However, the Fed can use its three tools—open market operations, reserve requirements, and interest on reserves—to influence the money supply and the inflation rate.

Question: What policies would reduce the growth rate of money and the inflation rate?



Answer: Open market sales, increased reserve requirements, and paying interest on reserves would reduce the growth rate of money and the inflation rate.



The third consequence of the Fed’s management of bank reserves is its influence over long-term interest rates by altering inflationary expectations:

Real interest rate = Nominal interest rate – Inflation rate



Investment decisions depend on long-term expected real interest rates.

Long-term indicates 10 years or more.

The expected real interest rate is the nominal interest rate minus expected inflation.



There are two types of real interest rates:

Realized real interest rate = Nominal interest rate – Realized inflation rate

Expected real interest rate = Nominal interest rate – Expected inflation rate



Monetary policy in the form of open market operations can impact long-term interest rates.

Think of a 10-year loan rate as 10 1-year loans lined up one after the other:



Questions:

What is the nominal 10-year interest rate for a federal funds rate target of 4%?

What is the nominal 0-year interest rate for a federal funds rate of 3% for the first two years and 4% afterward?



Answer: The 10-year nominal interest rates are:

4% 4% 4% 4% 4% 4% 4% 4% 4% 4% = 4.0%

10

3% 3% 4% 4% 4% 4% 4% 4% 4% 4% = 3.8%

10



Question: What would be the real 10-year interest rate if inflationary expectations remained at 2%?



Answer:

10-year real interest rate = 10-year nominal interest rate – Inflationary expectations

10-year real interest rate = 4.0% – 2.0% = 2.0%

10-year real interest rate = 3.8% – 2.0% = 1.8%



The Fed can reduce the short-term federal funds rate to lower long-term expected real interest rates.

A 1% reduction in the federal funds rate target translates into a less than 1% reduction in long-term expected real interest rates.

In most cases, inflationary expectations stay about the same.