ECO102

MacroeconomicsLecture 6

1ECO201 Macroeconomics

Chapter 25: The Money Supply and the Federal Reserve System

An Overview of Money

" What Is Money?

! Commodity and Fiat Monies

! Measuring the Supply of Money in the United States! The Private Banking System

How Banks Create Money

! The Modern Banking System

! The Creation of Money

! The Money Multiplier

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How the Central Bank Controls the Money Sup-ply

! The Required Reserve Ratio

! The Discount Rate

! Open Market Operations

! Excess Reserves and the Supply Curve for Money

The Central Bank of Turkey

! Brief History

! Organization Structure

! Duties and Powers

! Objectives

Review Questions

ECO102 Macroeconomics

The Money Supply and the Federal Reserve System

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What Is Money?

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

A Means of Payment, or Medium of Exchange

barter

The direct exchange of goods and services for other goods and services.

medium of exchange, or means of payment

What sellers generally accept and buyers generally use to pay for goods and services.

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A Store of Value

An asset that can be used to transport purchasing power from one time period to another.

liquidity property of money

The property of money that makes it a good medium of ex-change as well as a store of value: It is portable and read-ily accepted and thus easily exchanged for goods.

A Unit of Account

A standard unit that provides a consistent way of quoting prices.

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Commodity and Fiat Moniescommodity monies

Items used as money that also have intrinsic value 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 accepted in settlement of debts.

currency debasement

The decrease in the value of money that occurs when its supply is in-creased rapidly.

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Measuring the Supply of Money

M1, or transactions money

Money that can be directly used for transactions.

M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

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M2: Broad Money

near monies

Close substitutes for transactions money, such as savings accounts and money market accounts.

M2, or broad money

M1 plus savings accounts, money market accounts, and other near monies.

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

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Beyond M2

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

This poses problems for economists and those in charge of economic policy.

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financial intermediaries

Banks and other institutions that act as a link between those who have money to lend and those who want to bor-row money.

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

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The Modern Banking System

A Brief Review of Accounting

Assets − Liabilities ≡ Net Worth or

Assets ≡ Liabilities + Net Worth

Federal Reserve Bank (the Fed)

The central bank of the United States.

reserves

The deposits that a bank has at the Central Bank plus its cash on hand.

required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Central Bank.

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A Brief Review of Accounting

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excess reserves

The difference between a bank’s actual reserves and its re-quired reserves.

excess reserves ≡ actual reserves − required reserves

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The Money Multiplier

An increase in bank reserves leads to a greater than one-for-one in-crease in the money supply.

Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multi-plier.

money multiplier

The multiplier by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio.

ratio reserve required1 multiplier money ≡

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Functions of the Central Bank

• control the money supply.

• clear interbank payments,

• regulate the banking system,

• assist banks in a difficult financial position.

• manage exchange rates and the nation’s foreign exchange re-serves.

It is often involved in inter-country negotiations on international economic issues.lender of last resort One of the functions of the Central Bank: It provides funds to troubled banks that cannot find any other sources of funds.

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If the Central Bank wants to increase the supply of money, it creates more reserves, thereby freeing banks to create ad-ditional deposits by making more loans. If it wants to de-crease the money supply, it reduces reserves.

Three tools are available to the Central Bank for changing the money supply:

• Changing the required reserve ratio.

• Changing the discount rate.

• Engaging in open market operations.

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The Required Reserve Ratio

Decreases in the required reserve ratio allow banks to have more deposits 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 sup-ply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient re-serves and must therefore reduce their deposits by “calling in” some of their loans.

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The Discount Rate

The interest rate that banks pay to the Central Bank to bor-row from it.

moral suasion

The pressure that in the past the Central Bank exerted on member banks to discourage them from borrowing heavily from the Central Bank.

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Open Market Operations

The purchase and sale by the Central Bank of government securities in the open market; a tool used to expand or con-tract the amount of reserves in the system and thus the money supply.Two Branches of Government Deal in Government Securities

The Treasury Department is responsible for collecting taxes and paying the government’s bills.

The Central Bank is not the Treasury. It is a quasi-independent agency authorized by Congress to buy and sell outstanding (preex-isting) government securities on the open market.

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Open Market Operations

The Mechanics of Open Market Operations

■!An open market purchase of securities by the Central Bank results in an increase in reserves and an increase in the supply of money by an amount equal to the money multi-plier times the change in reserves.

■!An open market sale of securities by the Central Bank re-sults in a decrease in reserves and a decrease in the sup-ply of money by an amount equal to the money multiplier times the change in reserves.

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Excess Reserves and the Supply Curve for Money

If the Central Bank’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line.

Through its three tools, the Central Bank is assumed to have the money supply be what-ever value it wants.

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Brief History:During the Ottoman Empire Period:

Economic activities such as Treasury operations, money and credit transactions and trade in gold and foreign currencies were executed by various establishments such as the Treasury, the Mint, jewelers, money lenders, foundations and guilds.

The Ottoman Empire minted gold coins on behalf of the Sultan. The Ottoman Empire put cash banknotes (Kaime-i nakdiye-i mutebere) into circulation in 1840. 

The Ottoman Empire borrowed from abroad for the first time in 1854. Thus, a need for a state bank to assume an intermediary function in the repayment of external debts arose. As a result, the “Ottoman Bank” was established with English capital in 1856.

The Ottoman Bank was replaced with Imperial Ottoman Bank in 1863. The Imperial Otto-man Bank was granted the sole privilege of issuing banknotes for a period of thirty years. The Bank, acting as Treasurer of the State, was assigned to collect state revenues, make payments on behalf of the Treasury and discount Treasury bills, as well as making inter-est and principal payments pertaining to domestic and foreign debts.

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Following the First World War:

A global trend of nations to formulate their monetary policies independently by establish-ing their respective central banks, which would be authorized to issue money.

Similar trend in Turkey. To reinforce the political independence gained in the War of Inde-pendence with economic independence, efforts to establish a central bank in Turkey gained pace.

This issue was first held in the 1923 Izmir Economic Congress with a special emphasis on founding a “national state bank”.

In this period, Turkey exchanged views with the central banks of other countries.

Eventually, the law was enacted by the Grand National Assembly of Turkey on 11 June 1930, and published in the Official Gazette of 30 June 1930.

The Central Bank of the Republic of Turkey (CBRT) started to function on 3 October 1931.

1930’s - Utmost importance to independence of the CBRT was given. The Government could not intervene in the Bank’s field of authority and decisions.

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1940’s - Dominated by the adverse effects of the Second World War, the CBRT, like its peers all over the world, implemented policies to offset the public finance deficit rather than implementing an independent monetary policy.

1950’s -  Growth and rapid development financed by CBRT sources through short-term advances provided to the Treasury.

1960’s - The CBRT continued to provide resources to the public sector by pursuing expansionary monetary policies.

1970 - A new law on the CBRT. In order to adjust to the global changes that occurred in the after-math of the Second World War and to enhance the efficiency of the CBRT.

1980’s - With the launch of the financial liberalization process, important steps were taken to en-sure the necessary infrastructure for implementation of monetary and exchange rate policies in compliance with the market economy.

Following the destructive financial crises of 2000 and 2001, a transformation process in the Turk-ish economy has started. An IMF led program entitled «Transition to Strong Economy». Central Bank independence brought about by amendments in the Law & New monetary policy framework.

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TCMB Organization Structure

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The Board shall be composed of the Governor and six members to be elected by the General Assembly, for a three year period.

Duties and Powers:

To take decisions concerning monetary policy and monetary policy instruments;

To set forth regulations and to take decisions for the replacement of banknotes in circulation and their withdrawal from circulation and their destruction;

To establish the procedures and conditions and to enact necessary regulations regarding open market operations, for-eign exchange operations, rediscount and advance operations as well as rediscount and advance interest rates, re-serve requirements and liquidity requirement, other monetary policy operations and instruments, management of gold and foreign exchange reserves of the country;

To take decisions for the establishment of payment, securities transfer and settlement systems on conditions that shall promote their soundness and effectiveness, to determine the procedures and conditions of payment methods and instru-ments, to draw up regulations regarding the surveillance and supervision of clearing houses,

To enact regulations and to render decisions pertaining, to the establishment of branches, representative offices, bu-reaux and the appointment of correspondents and, to Banknote Printing House;

To decide on issues concerning provisions and reserves and to determine the procedures and conditions regarding the transfer of the balance to the Treasury, remaining after the allocation of profit,

To prepare the budget, annual report, balance sheet, income statements and the agenda of the General Assembly of the Bank.

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INSTRUMENTS"" " " " KEY INDICATORS" " " " " " OBJECTIVES

Reserve Requirements

Macro-prudential Tools

Credit Policy

Interest Rate Policy" ! ! ! Expectations ! ! ! ! ! ! Price Stability! !

Liquidity Policy " ! ! ! ! Credit Growth

Weekly Repo!! ! ! ! ! ! Exchange Rate! ! ! ! ! " Financial Stability

Interest Rate Corridor!

Funding Strategy

Policy Mix

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1) MoneyA) is necessary to conduct economic transac-tions.B) facilitates specialization in production.C) is anything the government declares to have value.D) is anything that is regularly used and generally accepted in economic transactions or exchanges.

Chapter 25 Review

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D) is anything that is regularly used and generally accepted in economic transactions or exchanges.

2) A barter transaction involves exchang-ingA) one good for another good.B) money for a service.C) one good for money.D) a service for a promise of a future monetary payment.

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2 A) one good for another good.

3) When you pay $8 for salad you or-dered for lunch, you are using money as a(n)A) store of value.B) investment good.C) medium of exchange.D) unit of account.

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3 C) medium of exchange.

4) When you keep your savings in a sav-ing account, you are using money as a(n)A) investment good.B) store of value.C) medium of exchange.D) unit of account.

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4 B) store of value.

5) The main disadvantage of using money as a store of value is thatA) money is not portable.B) it requires a double coincidence of wants.C) currency is intrinsically worthless.D) the value of money actually falls when the prices of goods and services rise.

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5 D) the value of money actually falls when the prices of goods and services rise.

6) The Turkish Lira is an example of fiat (to-ken) money becauseA) it is the strongest currency in the world.B) it is the most widely used currency in in-ternational trade.C) it is backed by a large reserve of gold and silver.D) by law, it is declared as money.

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6 D) by law, it is declared as money.

7) Currency debasement occurs whenA) items are used as money that also have intrin-sic value in some other use.B) the government requires that a certain form of money must be accepted in settlement of debts.C) items are designated as money that are intrinsi-cally worthless.D) the value of money falls as a result of a rapid in-crease in its supply.

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7 D) the value of money falls as a result of a rapid increase in its supply.

8) Currency held outside banks + demand deposits + travelers checks + other check-able deposits =A) M3.B) M2 - M1.C) M3 - M1.D) M1.

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7 D) M1.

8) Transaction money isA) M1.B) M2.C) M3.D) M4.

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8 A) M1.

9) Which of the following would NOT be counted as part of M1?A) demand depositsB) traveler's checkC) money market accountsD) currency

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9 C) money market accounts.

10) Currency held outside banks is in-cluded inA) both M1 and M2.B) M2 only.C) M1 only.D) neither M1 nor M2.

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10 A) both M1 and M2.

11) Close substitutes for transactions money are known asA) fiat monies.B) near monies.C) commodity monies.D) token monies.

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11 B) near monies.

12) Commercial banksA) implement monetary policy.B) are nonprofit organizations that lend and borrow funds.C) are financial intermediaries that lend funds and accept deposits.D) hold reserves against bank capital.

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12 C) are financial intermediaries that lend funds and accept deposits.

13) Istanbul National Bank has liabilities of $3 million and net worth of $200,000. Is-tanbul National Bank's assets areA) $200,000.B) $2.8 millionC) $3.0 million.D) $3.2 million.

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13 D) $3.2 million.

14) Things that a firm owns that are worth something are classified asA) liabilities.B) assets.C) deposits.D) net worth.

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14 B) assets.

15) Which of the following is considered a liability to a bank?A) time depositsB) reservesC) the bank's loansD) the bank's buildings and equipment

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15 A) time deposits.

16) First Commercial Bank's excess re-serves equal $_.A) 200,000 B) 600,000 C) 1,000,000 D) 1,500,000

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16 B) 600,000.

17) The required reserve ratio

A) is 5% B) is 10% C) is 20% D) cannot be determined from the given information.

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17 B) is 10% .

18) First Commercial Bank's total loans equal $________.A) 1,000,000B) 1,700,000C) 2,500,000D) 5,000,000.

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18 B) 1,700,000.

19) Narnia National Bank has $750 million in deposits. The required reserve ratio is 30%. Narnia National Bank must keep ________ in reserves.A) $125 millionB) $150 millionC) $225 millionD) $250 million

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19 C) $225 million.

20) Commercial banks create money throughA) printing treasury notes.B) making loans.C) facilitating borrowing from the Central Bank to the public.D) reducing risk in the economy.

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20 B) making loans.

21) The required reserve ratio is 5%. The money multiplier isA) 0.5.B) 5.C) 15.D) 20.

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21 D) 20.

22) Which of the following is NOT a tool available to the Central Bank to change the supply of money?A) open market operationsB) the required reserve ratioC) the money multiplierD) the discount rate

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22 C) the money multiplier.

23) Which of the following represents an action by the Central Bank that is designed to increase the money supply?A) a decrease in the required reserve ratioB) an increase in the discount rateC) a decrease in tax ratesD) selling government securities in the

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23 A) a decrease in the required reserve ratio.

24) An open-market sale of securities by the Central Bank results in ________ in reserves and ________ in the supply of money.A) an increase; a decreaseB) an increase; an increaseC) a decrease; an increaseD) a decrease; a decrease

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24 D) a decrease; a decrease.