Chapter 29 Lecture Notes PDF

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Lecture notes from Principles of Economics by Mankiw...

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Chapter 29: The Monetary System

What Money Is and Why It’s Important • Without money, trade would require barter, the exchange of one good or service for another. • Every transaction would require a double coincidence of wants— the unlikely occurrence that two people each have a good the other wants. • This searching is unnecessary with money, the set of assets that people regularly use to buy goods and services from other people.

Three Functions of Money • Medium of Exchange: an item buyers give to sellers when they want to purchase goods and services

- We use money to pay for the stuff we buy - Money is unique – our sellers will not accept any of our - Other assets in payment for the stuff they sell - New alternative - Bitcoin • Unit of Account: the yardstick people use to post prices and record debts

- In the U.S., everything is measured in dollars - What would happen if every store had its own way of measuring prices? - Price Chopper sells one gallon of milk for 3 globules. - Wegmans sells a gallon of milk for 5 fribbles. - How would that work? What is the REAL price of a gallon of milk? • Store of Value: an item people can use to transfer purchasing power from the present to the future

- You don’t have to spend all your dollars when you get them → you can hold them to spend later, and they will buy roughly the same amount of stuff (subject to inflation)!

Two Kinds of Money Commodity Money: takes the form of a commodity with intrinsic value (gold coins, cigarettes in POW camps, shells in Pacific islands, wampum) Fiat Money: money without intrinsic value, used as money because of government decree (the U.S. dollar → the dollar is worth $1, not because it has any value, but because the government says it is)

Money Supply: (money stock) the quantity of money available in the economy What assets should be considered part of the money supply? • Currency: the paper bills and coins in the hands of the (non-bank) public • Demand Deposits: balances in bank accounts that depositors can access on demand by writing a check M1: currency, demand deposits, traveler’s checks, and other checkable deposits M2: everything in M1 plus savings deposits, short-term deposits, money market mutual funds, and a few minor categories

Central Bank: an institution that oversees the banking system and regulates the money supply Federal Reserve (Fed): the central bank of the U.S. Monetary Policy: how policymakers in the central bank set the money supply

Bank Reserves! In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans. The Federal Reserve establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. Banks may hold more than this minimum amount if they choose. The Reserve Ratio, R = fraction of deposits that banks hold as reserves = total reserves as a percentage of total deposits !

T-Account: a simplified accounting statement that shows a bank’s assets & liabilities. Banks’ liabilities include deposits, assets include loans & reserves

A functioning banking system can create money!!! Money Multiplier: the amount of money the banking system generates for every dollar of reserves. (1/R)

• Assets: besides reserves and loans, banks also hold securities. • Liabilities: besides deposits, banks also obtain funds from issuing debt and equity. • Bank Capital: the resources a bank obtains by issuing equity to its owners (can be calculated as bank assets minus bank liabilities • Leverage: the use of borrowed funds to supplement existing funds for investment purposes

• Leverage Ratio: the ratio of assets to bank capital. • In this example, the leverage ratio = $1,000/$50 = 20 • What does this mean? for every $1 in assets the bank holds, • $0.05 is from the bank’s owners (note – NOT the bank’s depositors → depositors don’t own the bank!) • $0.95 is financed with borrowed money.

• Leverage Amplifies BOTH Profits and Losses • In our example, suppose bank assets appreciate by 5%, from $1,000 to $1,050. This increases bank capital from $50 to $100 [the increase all goes to the owners, doubling their equity]. • Suppose, instead, if bank assets decrease by 5%, bank capital falls from $50 to $0. • If bank assets decrease by more than 5%, bank capital is negative and bank is insolvent. • Capital Requirement: a government regulation that specifies a minimum amount of capital, intended to ensure banks will be able to pay off depositors and debts. • This is similar to a reserve requirement

Leverage and the Financial Crisis • In the financial crisis of 2008–2009, banks suffered losses on mortgage loans and mortgagebacked securities due to widespread defaults. • Many banks became insolvent: In the U.S.:

- 27 banks failed during 2000–2007 - 166 during 2008–2009 - The federal government had to step in and bail out depositors • Many other banks found themselves with too little capital o they responded by reducing lending

- This caused a credit crunch. The Government’s Response • To ease the credit crunch, the Federal Reserve and U.S. Treasury injected hundreds of billions of dollars’ worth of capital into the banking system. • This unusual policy temporarily made U.S. taxpayers part- owners of many banks. • The policy succeeded in recapitalizing the banking system and helped restore lending to normal levels in 2009.

- It also helped ease the crisis and make it shorter than it would have been without government intervention

The Fed’s Tools of Monetary Control • The Fed can change the money supply by changing:

- Bank Reserves - The Money Multiplier • Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.

- If the Fed buys a government bond from a bank, it pays by depositing new reserves in that bank’s reserve account.

- It injects cash (money) into the system → M1 increases - With more reserves, the bank can make more loans, increasing the money supply. - To decrease bank reserves and the money supply, the Fed sells government bonds. - It soaks up cash (money) out of the system → M1 decreases • The Fed can also influence reserves by making loans to banks

- The Fed makes loans to banks, increasing their reserves. - Traditional Method: adjusting the discount rate—the interest rate on loans the Fed makes to banks—to influence the amount of reserves banks borrow

- The more banks borrow, the more reserves they have for funding new loans and increasing the money supply. • The Fed can alter the Reserve Ratio. The Fed sets reserve requirements: regulations on the minimum amount of reserves banks must hold against deposits. Reducing the reserve requirement lowers the reserve ratio and increases the money multiplier. • The Fed can also pay higher interest on reserves held with it.

- Raising this interest rate would: - Attract more such deposits – deposits from banks into the Fed - Increase the reserve ratio - Lower the money multiplier Problems Controlling the Money Supply • If households hold more of their money as currency:

- Banks have fewer reserves

- Banks make fewer loans - Money supply falls • If banks hold more reserves than required, they make fewer loans, and money supply falls. • Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.

Run on Banks: When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits. • Under fractional-reserve banking, banks don’t keep enough cash to pay off ALL depositors, hence banks may have to close As a strategy against this, if banks perceive they are at risk of a bank run, they may: • Make fewer loans • Hold more reserves to satisfy depositors. These events: • Increase R • Reverse the process of money creation, and o cause money supply to fall

The Federal Funds Rate • On any given day, banks with insufficient reserves can borrow from banks with excess reserves. • The interest rate on these loans is the federal funds rate. • The federal funds rate is the rates that commercial banks charge each other for short term loans. • The FOMC uses OMOs to target the fed funds rate. • Changes in the fed funds rate cause changes in other rates and have a big impact on the economy.

To raise fed funds rate, Fed sells gov’t bonds. • Soaks up cash from the financial system • Removes reserves from the banking system • Reduces supply of federal funds • Causes rf to rise

In sum . . . • Money serves three functions:

- Medium of exchange - Unit of account - Store of value. • There are two types of money:

- Commodity money has intrinsic value - Fiat money does not. - The U.S. uses fiat money, which includes currency and various types of bank deposits. Summary • In a fractional reserve banking system, banks create money when they make loans. • Bank reserves have a multiplier effect on the money supply. • Because banks are highly leveraged, a small change in the value of a bank’s assets causes a large change in bank capital. • To protect depositors from bank insolvency, regulators impose minimum capital requirements. • The Federal Reserve is the central bank of the U.S. • The Fed is responsible for regulating the monetary system. • The Fed controls the money supply mainly through open-market operations. • Purchasing government bonds increases the money supply, selling government bonds decreases it. • In recent years, the Fed has set monetary policy by choosing a target for the federal funds rate.

MindTap

Liquidity refers to how quickly an asset can be converted into a medium of exchange. Cash or currency can be used immediately as a medium of exchange, so a $20.00 bill is the most liquid asset listed here. The funds in a money market account must be withdrawn before they can be used to purchase goods and services, but this transaction usually can be done within a day or two, assuming the account is with a local bank. A broker can sell a bond issued by a publicly traded company within a short period of time, and then it may take a few days for the accounts to settle and for you to receive your cash. Your car is the least liquid of the assets because it may take weeks or even months to find a buyer and get your cash.

Open Market Operations are the Fed's primary tool for controlling the money supply. Open market operations involve buying and selling U.S. government bonds. To increase the money supply, the Fed creates dollars with which to purchase government bonds from the public. After the purchase, the Fed has bonds and the public has new dollars—an increase in the money supply. To reduce the money supply, the Fed sells U.S. government bonds to the public. After the sale, the public has bonds and the Fed has taken dollars out of circulation, thereby reducing the money supply.

The Federal Reserve regulates the U.S. banking system to ensure its health. If a bank finds itself short on cash, with nowhere else to turn, the Fed steps in as a lender of last resort in order to prevent bank failures that might jeopardize the stability of the overall banking system.

To reduce the federal funds rate, the Federal Reserve uses open-market operations to buy government bonds from the public. The Federal Reserve's government bonds purchase injects reserves into the banking system. With additional reserves, banks are no longer as close to their

required reserve ratio, so the need for banks to borrow from each other declines, pushing the federal funds rate downward. Similarly, the Federal Reserve sells government bonds in order to raise the federal funds rate. The sale of government bonds reduces the quantity of reserves in the banking system, causing banks' need to borrow from each other to rise, pushing the federal funds rate upward.

Banks can borrow funds from the Federal Reserve to make more loans when their own reserves approach the minimum amount allowed by the required reserve ratio. An increase in the discount rate makes borrowing from the Federal Reserve more expensive for banks. Because banks know that lending past the required reserve ratio will be more costly, they will be stingier with their lending, and fewer loans will be made. Fewer loans made means less money is created. A decrease in the discount rate has the opposite effect. Borrowing from the Federal Reserve becomes less expensive, so banks borrow more reserves from the Federal Reserve, increasing the level of reserves in the banking system. The injection of reserves allows banks to make more loans, creating additional money and increasing the money supply....