Principles of Economics Session 12. Topics To Be Covered Definition of Money Categories of Money ...
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Transcript of Principles of Economics Session 12. Topics To Be Covered Definition of Money Categories of Money ...
Topics To Be Covered
Definition of MoneyCategories of MoneyThe Federal Reserve SystemMoney MultiplierSupply and Demand for MoneyEquilibrium of the Money MarketMonetary Policy
Definition of Money
Money is the set of assets in the economy that people regularly use to buy goods and services from other people.
It serves three functions: Medium of exchange Unit of account Store of value
Three Functions of Money
A medium of exchange is anything that is readily acceptable as payment.
A unit of account is the yardstick people use to post prices and record debts.
A store of value is an item that people can use to transfer purchasing power from the present to the future.
Barter
Barter is the direct exchange of goods and services for other goods and services.
A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem.
Money as a means of payment, or medium of exchange, is more efficient than barter.
Categories of Money
Commodity MoneyCommodity money takes the form of a commodity with intrinsic value. For example: Gold, silver, cigarettes.
Fiat MoneyFiat money is used as money because of government decree. It does not have intrinsic value. For example: Coins, currency, check deposits.
Money in the U.S. EconomyMeasur
eAmount in
2000What’s Included
M1 $1,103 billion CurrencyTraveler’s checksDemand depositsOther checkable deposits
M2 $4,778 billion Everything in M1Saving depositsSmall time depositsMoney market mutual funds
M3 $5,505 billion Everything in M2Large time deposits
The Central Bank Generally, the central bank of a country
serves the following functions: It oversees the banking system. It acts as a banker’s bank, making loans to
banks and as a lender of last resort. It conducts monetary policy by controlling the
money supply.
The Chinese central bank is the People’s Bank of China and the American one is the Federal Reserve System.
The Fed’s Organization
The Federal Reserve System (Fed) consists of : The Board of Governors
The Regional Federal Reserve Banks
The Federal Open Market Committee
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.
The Fed’s Organization
The Fed also includes 12 regional reserve banks.
Each regional reserve bank consists of nine directors—three appointed by the Board of Governors and six elected by the commercial banks in the district.
The directors appoint the district president which is approved by the Board of Governors.
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 votes on a yearly rotating basis).
The Fed’s Organization
FOMC serves as the main policy-making organ of the Federal Reserve System.
FOMC meets approximately every six weeks to review the economy.
FOMC conducts the monetary policy
The Fed’s Organization
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
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.
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.
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.
Money Creation
Banks can influence the quantity of demand deposits in the economy and the money supply.
In a fractional reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.
When a bank makes a loan from its reserves, the money supply increases.
Money Creation
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 (R).
Loans become an asset to the bank.
Money Creation
This T-Account shows a bank that:
accepts deposits keeps a portion as
reserves lends out the rest.
It assumes a reserve ratio of 10%.
Assets Liabilities
First Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
Money Creation
When one bank loans money, that money is generally spent. And the recipient deposits it 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.
Assets Liabilities
First Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
Assets Liabilities
Second Bank
Reserves$9.00
Loans$81.00
Total Assets$90.00
Total Liabilities$90.00
Money Supply = $190.00
Money Creation
Deposits$90.00
Money Creation
Original deposit = $ 100.00First lending = $ 90.00 [=0.9 x $100.00]Second lending = $ 81.00 [=0.9 x $90.00]Third lending = $ 72.90 [=0.9 x $81.00]
……………………………………………………….
000,1$9.01
100$M s
The Money Multiplier
The money multiplier is the amount of money the banking system generates with each dollar of reserves.
R
1M s
Supply and Demand for Money
In the money market, interest rates are determined by the supply and demand for money.
The central bank can change the interest rate level because it controls the supply of money.
The Demand for Money (The Liquid Preference)
Portfolio of holding financial wealth: stocks, bonds or money.
Holding wealth in currency or checking deposits means loss of potential income from interest on bonds and dividends on stocks.
The Demand for Money
The market rate of interest is the opportunity cost of holding money.
As interest rates rise, the opportunity cost of holding money rises, and the public demands less money. So the demand curve is downward sloping.
Macroeconomic variables that change the demand for money are price level and real GDP.
Demand for Money andthe Price Level
Money
Interest Rate Ms
Md1
r1
Md2
r2
When the price level rises, the
demand for money increases.
Demand for Money andthe Real GDP
Money
Interest Rate Ms
Md1
r1
Md2
r2
When real GDP rises, the demand
for money increases.
The Demand for Money
Generally, the motives of people holding money can be roughly classified into two categories.
Transaction demand for money
Speculative demand for money
The Demand for Money
Transaction demand for moneyThe needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs.
Speculative demand for moneyAn attitude that holding money over short periods is less risky than holding stocks or bonds.
The Transaction Demandfor Money
The transactions demand for money (L1) is based on the desire to facilitate transactions.
It mainly depends on the income (Y), so its function is:
) (Y L L1 1
The Speculative Demandfor Money
The speculative demand for money (L2) is based on the desire to make wise decisions to invest in securities such as bonds.
It mainly depends on the interest, so its function is:
) (r L L2 2
Bond Prices and Interest Rates
Bonds are promises to pay money in the future. The price of a bond one year from now is the promised payment divided by 1 plus the interest rate.
Bond Prices and Interest Rates
For example, a bond that promises to pay $106 a year, with an interest rate is 6% per year, would cost today:
In other words, if you can invest at 6% per year, you would be willing to pay $100 today for a $106 promised payment next year.
100$0.061
$106 bond of icePr
Interest Rates and Bond Prices
Bond prices change in the opposite direction from changes in interest rates:
p rice o f b o nd
$ 1 0 6
( . )$ 1 0 0
1 0 0 6 1
If the interest rate rose to 8%, how much would you like to pay?
Interest Rate
Promised Payment
$106 6%
p rice o f b o nd
$ 1 0 6
( . )$ 1 0 1.
1 0 0 49 21
Interest Rate
Promised Payment
$106 4%
$98.15.
Interest Rates and Bond Prices
When interest rates rise, investors need less money to obtain the same promised payments in the future, so the price of bonds falls.
Therefore, bonds’ prices are inversely related to interest rates.
The Speculative Demandfor Money
When the interest is high, the bond price is low. Usually people will guess that the bond price is to rise, so they purchase bonds, thus having less money in hand.
Lessmoneyin hand
highinterest
rates
Purchasingbonds
Lowbondprices
The Speculative Demandfor Money
When the interest is low, the bond price is high. Usually people will expect that the bond price is to fall, so they sell the bonds they own. Consequently they have more money in hand.
Moremoneyin hand
Lowinterest
rates
Sellingbonds
Highbondprices
Equilibrium of the Money Market
L m When the money market is at equilibrium,
the demand for money (L) should be equal to the supply of money (m).
The money supply is controlled by the central bank.
Equilibrium of the Money Market
m
rL
m1
m1
r1E
When money demand and supply equal, the money
market is at equilibrium
Central Bank and Interest Rates
The central bank can influence the interest rate through changing the money supply.
An increase in the money supply leads to a lower interest rate.
A decrease in the money supply leads to a higher interest rate.
Monetary Policy
Monetary policy is the range of actions taken by the Federal
Reserve to influence the level of GDP or the rate of inflation.
Monetary Policy
The central bank can influence the output by changing the money supply.
When the central bank increase the money supply, the interest rate goes down.
With the decrease of interest rate, the investment increases.
Since increase is part of GDP, the total output increases.
Monetary Policy
r1 r1
MdMs2Ms1 I2
I1 Y2Y1
AE1
AE2
Money Investment
Output
r2 r2
GDP increases
Open market
purchase
Money supply
increases
Interest rates fall
Investment spending
rises
Limitations of Monetary Policy
If the economy has reached the level of potential output, namely, the full-employment output, the expansionary monetary policy won’t work effectively.
Initially, monetary expansion leads to output above full employment. The demand for money increases, leading to a higher interest rate.
The increase of interest rate will decrease the investment, which will return the GDP back to the full-employment level.
Limitations of Monetary Policy
r1 r1
Md1
Ms2Ms1 I2I1 Y2
AE1
AE2
Money Investment
Output
r2 r2
Y1
Potential GDP
Md2
Assignment
Review Chapter 25 and 26.Answer questions on P491 and 513.Search for information on China’s
monetary policies in the recent years.Preview Chapter 29 and 30.