4
MONEY AND PRICES IN THE LONG RUN
Copyright © 2004 South-Western
99The Monetary
System
Copyright © 2004 South-Western
THE MEANING OF MONEY
• Money is the set of assets in an economy that
people regularly use t...
Copyright © 2004 South-Western
The Functions of Money
• Money has three functions in the economy:
• Medium of exchange
• U...
Copyright © 2004 South-Western
The Functions of Money
• Medium of Exchange
• A medium of exchange is an item that buyers g...
Copyright © 2004 South-Western
The Functions of Money
• Unit of Account
• A unit of account is the yardstick people use to...
Copyright © 2004 South-Western
The Functions of Money
• Liquidity
• Liquidity is the ease with which an asset can be
conve...
Copyright © 2004 South-Western
The Kinds of Money
• Commodity money takes the form of a
commodity with intrinsic value.
• ...
Copyright © 2004 South-Western
Money in the U.S. Economy
• Currency is the paper bills and coins in the
hands of the publi...
Figure 1 Money in the U.S. Economy
Copyright©2003 Southwestern/Thomson Learning
Billions
of Dollars
• Currency
($580 billi...
Copyright © 2004 South-Western
CASE STUDY: Where Is All The Currency?
• In 2001 there was about $580 billion of U.S.
curre...
Copyright © 2004 South-Western
THE FEDERAL RESERVE
SYSTEM
• The Federal Reserve (Fed) serves as the
nation’s central bank....
Copyright © 2004 South-Western
THE FEDERAL RESERVE
SYSTEM
• The Fed was created in 1914 after a series of
bank failures co...
Copyright © 2004 South-Western
THE FEDERAL RESERVE
SYSTEM
• The Structure of the Federal Reserve System:
• The primary ele...
Copyright © 2004 South-Western
The Fed’s Organization
• The Fed is run by a Board of Governors, which
has seven members ap...
Copyright © 2004 South-Western
The Fed’s Organization
• The Board of Governors
• Seven members
• Appointed by the presiden...
Copyright © 2004 South-Western
The Fed’s Organization
• The Federal Reserve System is made up of the
Federal Reserve Board...
Copyright © 2004 South-Western
The Fed’s Organization
• The Federal Reserve Banks
• Twelve district banks
• Nine directors...
The Federal Reserve System
Copyright©2003 Southwestern/Thomson Learning
Copyright © 2004 South-Western
The Fed’s Organization
• The Federal Reserve Banks
• The New York Fed implements some of th...
Copyright © 2004 South-Western
The Fed’s Organization
• The Federal Open Market Committee (FOMC)
• Serves as the main poli...
Copyright © 2004 South-Western
The Fed’s Organization
• The Federal Open Market Committee (FOMC)
is made up of the followi...
Copyright © 2004 South-Western
The Fed’s Organization
• Monetary policy is conducted by the Federal
Open Market Committee....
Copyright © 2004 South-Western
The Federal Open Market Committee
• Three Primary Functions of the Fed
• Regulates banks to...
Copyright © 2004 South-Western
The Federal Open Market Committee
• Open-Market Operations
• The money supply is the quanti...
Copyright © 2004 South-Western
The Federal Open Market Committee
• Open-Market Operations
• To increase the money supply, ...
Copyright © 2004 South-Western
BANKS AND THE MONEY
SUPPLY
• Banks can influence the quantity of demand
deposits in the eco...
Copyright © 2004 South-Western
BANKS AND THE MONEY
SUPPLY
• Reserves are deposits that banks have received
but have not lo...
Copyright © 2004 South-Western
BANKS AND THE MONEY
SUPPLY
• Reserve Ratio
• The reserve ratio is the fraction of deposits ...
Copyright © 2004 South-Western
Money Creation with Fractional-Reserve
Banking
• When a bank makes a loan from its reserves...
Copyright © 2004 South-Western
Money Creation with Fractional-Reserve
Banking
• This T-Account shows a bank that…
• accept...
Copyright © 2004 South-Western
Money Creation with Fractional-Reserve
Banking
• When one bank loans money, that money is
g...
Copyright © 2004 South-Western
The Money Multiplier
• How much money is eventually created in this
economy?
Copyright © 2004 South-Western
The Money Multiplier
• The money multiplier is the amount of money
the banking system gener...
Copyright © 2004 South-Western
The Money Multiplier
Assets Liabilities
First National Bank
Reserves
$10.00
Loans
$90.00
De...
Copyright © 2004 South-Western
The Money Multiplier
• The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R...
Copyright © 2004 South-Western
The Fed’s Tools of Monetary Control
• The Fed has three tools in its monetary toolbox:
• Op...
Copyright © 2004 South-Western
The Fed’s Tools of Monetary Control
• Open-Market Operations
• The Fed conducts open-market...
Copyright © 2004 South-Western
The Fed’s Tools of Monetary Control
• Reserve Requirements
• The Fed also influences the mo...
Copyright © 2004 South-Western
The Fed’s Tools of Monetary Control
• Changing the Reserve Requirement
• The reserve requir...
Copyright © 2004 South-Western
The Fed’s Tools of Monetary Control
• Changing the Discount Rate
• The discount rate is the...
Copyright © 2004 South-Western
Problems in Controlling the Money Supply
• The Fed’s control of the money supply is not
pre...
Copyright © 2004 South-Western
Summary
• The term money refers to assets that people
regularly use to buy goods and servic...
Copyright © 2004 South-Western
Summary
• The Federal Reserve, the central bank of the
United States, regulates the U.S. mo...
Copyright © 2004 South-Western
Summary
• When banks loan out their deposits, they
increase the quantity of money in the ec...
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9 monetary system

  1. 1. 4 MONEY AND PRICES IN THE LONG RUN
  2. 2. Copyright © 2004 South-Western 99The Monetary System
  3. 3. Copyright © 2004 South-Western THE MEANING OF MONEY • Money is the set of assets in an economy that people regularly use to buy goods and services from other people.
  4. 4. Copyright © 2004 South-Western The Functions of Money • Money has three functions in the economy: • Medium of exchange • Unit of account • Store of value
  5. 5. Copyright © 2004 South-Western The Functions of Money • Medium of Exchange • A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. • A medium of exchange is anything that is readily acceptable as payment.
  6. 6. Copyright © 2004 South-Western The Functions of Money • Unit of Account • A unit of account is the yardstick people use to post prices and record debts. • Store of Value • A store of value is an item that people can use to transfer purchasing power from the present to the future.
  7. 7. Copyright © 2004 South-Western The Functions of Money • Liquidity • Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.
  8. 8. Copyright © 2004 South-Western The Kinds of Money • Commodity money takes the form of a commodity with intrinsic value. • Examples: Gold, silver, cigarettes. • Fiat money is used as money because of government decree. • It does not have intrinsic value. • Examples: Coins, currency, check deposits.
  9. 9. Copyright © 2004 South-Western 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.
  10. 10. Figure 1 Money in the U.S. Economy Copyright©2003 Southwestern/Thomson Learning Billions of Dollars • Currency ($580 billion) • Demand deposits • Traveler’s checks •Other checkable deposits ($599 billion) • Everything in M1 ($1,179 billion) • Savings deposits • Small time deposits • Money market mutual funds • A few minor categories ($4,276 billion) 0 M1 $1,179 M2 $5,455
  11. 11. Copyright © 2004 South-Western CASE STUDY: Where Is All The Currency? • In 2001 there was about $580 billion of U.S. currency outstanding. • That is $2,734 in currency per adult. • Who is holding all this currency? • Currency held abroad • Currency held by illegal entities
  12. 12. Copyright © 2004 South-Western THE FEDERAL RESERVE SYSTEM • The Federal Reserve (Fed) serves as the nation’s central bank. • It is designed to oversee the banking system. • It regulates the quantity of money in the economy.
  13. 13. Copyright © 2004 South-Western THE FEDERAL RESERVE SYSTEM • The Fed was created in 1914 after a series of bank failures convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system.
  14. 14. Copyright © 2004 South-Western THE FEDERAL RESERVE SYSTEM • The Structure of the Federal Reserve System: • The primary elements in the Federal Reserve System are: • 1) The Board of Governors • 2) The Regional Federal Reserve Banks • 3) The Federal Open Market Committee
  15. 15. Copyright © 2004 South-Western The Fed’s Organization • The Fed is run by a Board of Governors, which has seven members appointed by the president and confirmed by the Senate. • Among the seven members, the most important is the chairman. • The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees.
  16. 16. Copyright © 2004 South-Western The Fed’s Organization • The Board of Governors • Seven members • Appointed by the president • Confirmed by the Senate • Serve staggered 14-year terms so that one comes vacant every two years. • President appoints a member as chairman to serve a four-year term.
  17. 17. Copyright © 2004 South-Western The Fed’s Organization • The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks.
  18. 18. Copyright © 2004 South-Western The Fed’s Organization • The Federal Reserve Banks • Twelve district banks • Nine directors • Three appointed by the Board of Governors. • Six are elected by the commercial banks in the district. • The directors appoint the district president, which is approved by the Board of Governors.
  19. 19. The Federal Reserve System Copyright©2003 Southwestern/Thomson Learning
  20. 20. Copyright © 2004 South-Western The Fed’s Organization • The Federal Reserve Banks • The New York Fed implements some of the Fed’s most important policy decisions.
  21. 21. Copyright © 2004 South-Western The Fed’s Organization • The Federal Open Market Committee (FOMC) • Serves as the main policy-making organ of the Federal Reserve System. • Meets approximately every six weeks to review the economy.
  22. 22. Copyright © 2004 South-Western The Fed’s Organization • The Federal Open Market Committee (FOMC) is made up of the following voting members: • The chairman and the other six members of the Board of Governors. • The president of the Federal Reserve Bank of New York. • The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis).
  23. 23. Copyright © 2004 South-Western The Fed’s Organization • Monetary policy is conducted by the Federal Open Market Committee. • Monetary policy is the setting of the money supply by policymakers in the central bank • The money supply refers to the quantity of money available in the economy.
  24. 24. Copyright © 2004 South-Western The Federal Open Market Committee • Three Primary Functions of the Fed • Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. • Acts as a banker’s bank, making loans to banks and as a lender of last resort. • Conducts monetary policy by controlling the money supply.
  25. 25. Copyright © 2004 South-Western The Federal Open Market Committee • Open-Market Operations • The money supply is the quantity of money available in the economy. • The primary way in which the Fed changes the money supply is through open-market operations. • The Fed purchases and sells U.S. government bonds.
  26. 26. Copyright © 2004 South-Western The Federal Open Market Committee • Open-Market Operations • 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.
  27. 27. Copyright © 2004 South-Western BANKS AND THE MONEY SUPPLY • Banks can influence the quantity of demand deposits in the economy and the money supply.
  28. 28. Copyright © 2004 South-Western BANKS AND THE MONEY SUPPLY • 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.
  29. 29. Copyright © 2004 South-Western BANKS AND THE MONEY SUPPLY • Reserve Ratio • The reserve ratio is the fraction of deposits that banks hold as reserves.
  30. 30. Copyright © 2004 South-Western Money Creation with Fractional-Reserve Banking • When a bank makes a loan from its reserves, the money supply increases. • The money supply is affected by the amount deposited in banks and the amount that banks loan. • Deposits into a bank are recorded as both assets and liabilities. • The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. • Loans become an asset to the bank.
  31. 31. Copyright © 2004 South-Western Money Creation with Fractional-Reserve Banking • 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
  32. 32. Copyright © 2004 South-Western Money Creation with Fractional-Reserve Banking • When one bank loans money, that money is generally deposited into another bank. • This creates more deposits and more reserves to be lent out. • When a bank makes a loan from its reserves, the money supply increases.
  33. 33. Copyright © 2004 South-Western The Money Multiplier • How much money is eventually created in this economy?
  34. 34. Copyright © 2004 South-Western The Money Multiplier • The money multiplier is the amount of money the banking system generates with each dollar of reserves.
  35. 35. Copyright © 2004 South-Western The Money Multiplier 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 Money Supply = $190.00!
  36. 36. Copyright © 2004 South-Western The Money Multiplier • The money multiplier is the reciprocal of the reserve ratio: M = 1/R • With a reserve requirement, R = 20% or 1/5, • The multiplier is 5.
  37. 37. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • The Fed has three tools in its monetary toolbox: • Open-market operations • Changing the reserve requirement • Changing the discount rate
  38. 38. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Open-Market Operations • The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: • When the Fed buys government bonds, the money supply increases. • The money supply decreases when the Fed sells government bonds.
  39. 39. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Reserve Requirements • The Fed also influences the money supply with reserve requirements. • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.
  40. 40. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Changing the Reserve Requirement • The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. • Increasing the reserve requirement decreases the money supply. • Decreasing the reserve requirement increases the money supply.
  41. 41. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Changing the Discount Rate • 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.
  42. 42. Copyright © 2004 South-Western Problems in 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.
  43. 43. Copyright © 2004 South-Western Summary • The term money refers to assets that people regularly use to buy goods and services. • Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value. • Commodity money is money that has intrinsic value. • Fiat money is money without intrinsic value.
  44. 44. Copyright © 2004 South-Western Summary • The Federal Reserve, the central bank of the United States, regulates the U.S. monetary system. • It controls the money supply through open- market operations or by changing reserve requirements or the discount rate.
  45. 45. Copyright © 2004 South-Western Summary • When banks loan out their deposits, they increase the quantity of money in the economy. • Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.

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