Eco exam

Chapter 22: Money, Prices, and the Federal Reserve

ECON 3 - Principles of Macroeconomics University of California San Diego

Christopher Gibson

Wednesday, April 29th - Monday, May 4th

What is money?

Without money, how would people obtain goods and services?

• barter - the direct trade of goods or services for other goods or services

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Animal pelts used to be a common item used for barter

Barter depends on a double coincidence of wants, a phenomenon where two parties each hold an item the other wants, so they exchange these items directly without any monetary medium.

Instead, we might prefer something that is universally agreed upon to be valuable, avoiding the double coincidence of wants.

• money - any asset that can be used in making purchases

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Animal pelts served as early forms of money, but their effectiveness depended on a shared belief in their value.

Money and its properties

We would like money to be widely agreed to be valuable. What are the other key roles does money serves?

1. medium of exchange - an asset used in purchasing goods and services

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Basically it has to satisfy the definition of money

2. unit of account - a basic measure of economic value

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Enables the value of different goods to be compared, even if rates of exchange between two goods cannot be directly observed

3. store of value - an asset that serves as a means of holding wealth

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Imagine if you were paid every two weeks with a box full of food; your “payment” would spoil before you could consume it all!

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Measuring money

We will focus on two measures of money called M1 and M2.

1. M1 - the sum of currency outstanding and balances held in checking accounts

2. M2 - all assets in M1 plus some additional assets that are usable in making payments but at a greater cost or inconvenience

Notice that the difference between assets only in M2 and those in M1 is liquidity.

• Liquidity is the ability to quickly convert an asset into spendable currency without losing its value

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the less value that is lost, the more liquid is the asset

Money and commercial banks

Before banks, people would store all of their money at home (under their mattresses, for exam- ple). Then people wanted to put their money into banks for at least two reasons.

1. It is risky to carry large amounts of cash, for fear of losing it

2. Banks may incentivize households to lend them their cash in exchange for paying interest

3. Making payments is easier when money is held in a bank.

Banks like taking customer’s cash

• Banks can lend out borrowed cash at a higher rate than they pay to borrow it!

But how much do they decide to lend out? Banks face competing incentives:

(i) The more cash banks lend out, the more they can make in terms of interest on these loans.

(ii) If banks lend out too much cash, they may not have enough to satisfy the demands of their clients, who may either withdraw cash or transfer it directly in order to make a payment (e.g. by writing a check)

Let us formalize the bank’s decision with a few definitions.

• bank reserves - cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments

• 100 percent reserve banking - a situation in which banks’ reserves equal 100 percent of their deposits

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This is one extreme of reserve banking

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Again, it is in the bank’s interest to hold fewer than 100 percent of deposits in reserve since they would like to earn interest by issuing loans. In fact, a 100 percent reserve banking system could not be sustainable, because banks have expenses (interest payments on deposits, storage for customers’ cash), and without income banks would go out of business!

Then as banks lend out their reserves and deposits remain, deposits exceed reserves! It is useful to introduce terminology to measure this.

• reserve-deposit ratio - bank reserves divided by deposits

• fractional-reserve banking system - a banking system in which bank reserves are less than deposits so that the reserve-deposit ratio is less than 100 percent

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As the definition implies, if reserves equal deposits, the reserve ratio is 100 percent and we have 100 percent reserve banking, as above.

• excess reserves - reserves that exceed the amount of reserves a bank would like to hold to satisfy their reserve-deposit ratio.

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If the bank would like to satisfy Reserves Deposits

= rr, then excess reserves are given by

Excess reserves = Reserves − rr · Deposits

Let’s look at how this results in money creation.

The creation of money

How is money created? The obvious answer is that the government prints it! But there is a more subtle means of money creation that we will explore here.

Money is created through:

1. The government issuing (e.g. printing) new currency; and

2. The process of deposit creation through a fractional-reserve banking system

Let’s look at an example.

An example of money creation: No currency held

Suppose the central bank in the new economy of Wynneweld issues 1000 notes of its new currency, the baskin. Not wanting to hold currency, the public brings this new currency to the only bank in town, Bank Exotic. In order to protect against running out of reserves to satisfy their clients’ demand for their deposits, the bank keeps 10% of deposits on reserve. These assumptions are summarized as follows.

• The government of Wynneweld distributes 1000 baskins to the public.

• The public does not want to hold any currency as cash, and will always deposit it into the bank

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• Bank Exotic is the only bank in town and it keeps 10% of its deposits as reserves.

If this were a 100 percent reserve banking system, the bank would keep all of these deposits and the total amount of money created in the economy would remain 1000 baskins. We know, however, that the bank will loan out 90% of its deposits.

In Step 1, the public deposits the 1000b currency into the bank, increasing reserves and deposits.

Step 1 Assets Liabilities

Reserves 1000b Deposits 1000b →

Step 2 Assets Liabilities

Reserves 100b Deposits 1000b Loans 900b

In Step 2, the bank loans out its 900b excess reserves, leaving it with reserve ratio Reserves Deposits

= 100b 1000b

= 0.1, as desired.

In Step 3, the public deposits the 900b loan since they do not wish to hold any cash, increasing reserves back to 1000b and deposits to 1900b.

Step 3 Assets Liabilities

Reserves 1000b Deposits 1900b Loans 900b

→

Step 4 Assets Liabilities

Reserves 190b Deposits 1900b Loans 2710b

In Step 4, given that banks have 1900b in deposits and would like to hold only 10% of this in reserves, Bank Exotic finds that it has 1000b − 190b = 810b in excess reserves. The bank will then loan out an additional 810b, increasing loans to 2710b and decreasing reserves to 190b.

In Step 5 and beyond, any loans issued will come back as deposits. Since reserves in Bank Exotic will always be 1000b after the public deposits their cash, this process will continue until deposits satisfy

Reserves

Deposits = 0.1 =⇒ Deposits =

Reserves

0.1 =

1, 000b

0.1 = 10, 000b

The final balance sheet after this process will look as follows.

Assets Liabilities Reserves 1,000b Deposits 10,000b Loans 9,000b

So the central bank printing 1000b resulted in the creation of 10,000b in deposits. This increases the money supply M1 by 10,000b

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The currency as reserves does not count in M1 because it is not currency in circulation.

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The money multiplier

This increase in deposits as a result of an influx of currency can also be found using the money multiplier. The money multiplier is the inverse of the reserve ratio. In particular, for a reserve ratio rr, the money multiplier is

MM = 1

rr

In our example, with rr = 0.1, MM = 1 0.1

= 10, so a 1000b increase in currency led to a 10 · 1000b = 10, 000b increase in deposits.

An example of money creation: Half of currency held

Consider the previous example, but suppose instead that the public will deposit only half of new currency issues. These new assumptions are summarized as follows.

• The government of Wynneweld distributes 1000 baskins to the public.

• The public deposit half on initial currency issues into the bank

• Bank Exotic is the only bank in town and it keeps 10% of its deposits as reserves.

Then if 500b is held in currency and 500b is deposited, using the money multiplier, total deposits increase by 10 · 500b = 5000b, so deposits increase to 5000b. The total money change in the money supply is the increase in currency in circulation (500b) and total deposits (5000b). The increase in the money supply is thus 5,500b.

Clearly then, monetary policy (how the government changes the money supply) is affected by at least two factors:

1. What percentage of deposits banks hold in reserves

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This will be referred to as the effective reserve ratio

2. How much money the public wishes to hold as currency

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This will be referred to as the demand for money

The federal reserve system

The Federal Reserve System (or the Fed) is the central bank of the United States

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Other central banks include the Bank of Canada (BoC), the Bank of Mexico (BdeM), the People’s Bank of China (PBoC), the European Central Bank (ECB)

The Fed’s key responsibilities include:

• Monetary policy - the determination of the nation’s money supply

• Supervision and regulation of financial markets

• Intervention in times of financial crisis (it’s more likely than you think).

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e.g. the Fed can loan directly to banks

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the Fed can change the reserve requirement, a much more extreme tool than mone- tary policy (in fact as of March 15th, 2020, the Fed decreased all reserve requirements to zero! https://www.federalreserve.gov/monetarypolicy/reservereq.htm)

The history of the Fed

Federal Reserve Act passed in 1913 and the Federal Reserve System started operations in 1914 in response to particularly severe banking panic in 1907.

In forming the Federal Reserve System, two competing forces needed to be balanced.

1. A central bank should be able to affect the money supply of the entire country, and should thus be centralized.

2. The culture of the United States is U.S. culture is averse to centralized power, having been founded as a country by fighting against the subjugation of the centralized government of Great Britain

The compromise to address these competing forces led to the following structure of the Federal Reserve System.

1. There are 12 regional Federal Reserve banks, each associated with a geographical area called a Federal Reserve district.

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Each bank is able to give input into the Fed’s decision making with knowledge of their district’s needs that is more accessible at the local level.

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San Diego is in district 12, whose main branch is in San Francisco.

• Board of governors - the leadership of the Fed, consisting of seven governors appointed by the president to staggered 14-year terms

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Terms are staggered so there is an appointment every two years (only one full term may be served by each governor).

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There are currently two vacant seats on the board.

• Federal Open Market Committee (FOMC) - the committee that makes decisions concerning monetary policy

– The FOMC consists of the seven Fed governors, the president of the Federal Reserve Bank of New York, and 4 rotating members of other regional Federal Reserve banks.

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The FRBNY president is always on the FOMC because monetary policy goes through the trading desk in the New York Fed.

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If there are un-appointed governors, those vacant seats on the board stay vacant on the FOMC.

• open-market operations - the buying and selling of government bonds to affect the money supply

• open-market purchase - the purchase of government bonds from the public by the Fed for the purpose of increasing the supply of bank reserves and the money supply

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The Fed executes open-market purchases in order to increase the money supply

• open-market sale - the sale by the Fed of government bonds to the public for the purpose of reducing bank reserves and the money supply

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The Fed executes open-market sales in order to decrease the money supply

Contractionary monetary policy: An example

Consider the example above, where the central bank’s addition of 1000 baskins in currency led to 10,000 baskins worth of deposits being created.

Assets Liabilities Reserves 1,000b Deposits 10,000b Loans 9,000b

What if, for whatever reason, the central bank decides that there should only be 9,000b worth of deposits in the economy? Given the money multiplier is 10, the government would need to remove 100b from the bank’s reserves. This would entail the open market sale of 100b worth of bonds, leading to a decrease of 10 · 100b = 1000b in deposits, and a final balance sheet as follows.

Assets Liabilities Reserves 900b Deposits 9,000b Loans 8,100b

Expansionary monetary policy: An example

What if instead the central bank instead decides to increase the money supply to 15,000b? Then it would execute an open market purchase of 500b worth of bonds, leading to an increase of 10 · 500b = 5000b in deposits, and a final balance sheet as follows.

Assets Liabilities Reserves 1,500b Deposits 15,000b Loans 13,500b

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How to stop a banking panic

• banking panic - a situation in which news or rumors of the imminent bankruptcy of one or more banks leads to bank depositors to rush to withdraw their funds

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If you think your bank is going to run out of money, it is rational to want to withdraw your deposits while the bank still has reserves to honor them!

In order to prevent this sort of “run” on banks, it is essential that customers believe that their deposits will remain accessible, even if the bank goes bankrupt! This is why in addition to the Federal Reserve System being created in 1913, the Federal Deposit Insurance Corporation (FDIC) was created in 1933 to stop banking panics.

• deposit insurance - a system under which the government guarantees that depositors will not lose any money, even if their bank goes bankrupt

– The Federal Deposit Insurance Corporation (FDIC) is the deposit insurance for the United States, created during the Great Depression by the 1933 Banking Act.

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Up to $100,000 worth of deposits were insured until 2008, when this limit was increased to $250,000 of deposits

The velocity of money

The velocity of money is a measure of how often money changes hands on average. It is defined as follows

velocity = value of transactions

money stock

In order to value transactions, we will take the nominal GDP, which is real GDP Y , scaled by the current price level P . Then velocity of money can be written as M ·V = P ·Y .

While this equation in itself is not so informative (V can take whatever value ensures that it holds), if we assume that velocity and real GDP are constant (at least in the short-term, then we have the following relationship.

M ·V = P ·Y

This implies that increases in the money supply lead to inflation. As the following graph shows, there is empirical support for this result.

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