The Money Supply and the Central Bank

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Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Money Supply andthe Central Bank

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2 of 42© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

An Overview of Money

• Money is anything that is generally accepted as a medium of exchange.

• Money is not income, and money is not wealth. Money is:

• a means of payment,

• a store of value, and

• a unit of account.

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What is Money?

• 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.

• As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

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What is Money?

• As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.

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What is Money?

• As a unit of account, money is a standard that provides a consistent way of quoting prices.

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What is Money?

• Money is easily portable, and easily exchanged for goods at all times.

• The liquidity property of money makes money a good medium of exchange as well as a store of value.

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Commodity and Fiat Monies

• Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money.

• Fiat, or token, money is money that is intrinsically worthless.

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Commodity and Fiat Monies

• Legal tender is money that a government has required to be accepted in settlement of debts.

• Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.

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Measuring the Supply ofMoney in the United States

• M1, or transactions money is money that can be directly used for transactions.

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

• M1 is a stock measure—it is measured at a point in time—on a specific day.

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Measuring the Supply ofMoney in the United States

• M2, or broad money, includes near monies, or close substitutes for transactions money.

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

• The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

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The Private Banking System

• Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

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How Banks Create Money

• A Historical Perspective: Goldsmiths

• Goldsmiths functioned as warehouses where people stored gold for safekeeping.

• Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves began to be traded for goods, and were backed 100 percent by gold.

• Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold.

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How Banks Create Money

• A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

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The Modern Banking System

• A brief review of accounting:

Assets – liabilities Net Worth, or

Assets Liabilities + Net Worth

• A bank’s most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the CB.

• A bank’s liabilities are its debts—what it owes. Deposits are debts owed to the bank’s depositors.

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The Modern Banking System

• Reserves are the deposits that a bank has at the Central Bank plus its cash on hand.

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

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T-Account for a Typical Bank

• The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).

T-Account for a Typical Bank (millions of dollars)

ASSETS LIABILITIES

Reserves 20 100 Deposits

Loans 90 10 Net worth

Total 110 110 Total

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The Creation of Money

• Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).

ex cess rese rv es ac tu a l re se rv es req u ired rese rv es

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• When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1 Panel 2 Panel 3

ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits

Loans 400

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• If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1 Panel 2 Panel 3

ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits

Loans 400

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The Creation of Money When There Are Many Banks

Panel 1 Panel 2 Panel 3ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 100 100 Deposits Reserves 100Loans 80

180 Deposits Reserves 20Loans 80

100 Deposits

Reserves 80 80 Deposits Reserves 80Loans 64

144 Deposits Reserves 16Loans 64

80 Deposits

Reserves 64 64 Deposits Reserves 64 115.20 Deposits Reserves 12.80 64 Deposits

.00500Total

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.2051Bank 464Bank 380Bank 2

100Bank 1DepositsSummary:

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The Money Multiplier

• The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.

• In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.

M o n ey m u ltip lie r =1

R eq u ired rese rv e ra tio.00500Total

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.2051Bank 464Bank 3

80Bank 2

100Bank 1DepositsSummary:

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Functions of the Central Bank

• Clearing interbank payments.

• Managing exchange rates and the nation’s foreign exchange reserves.

• Lender of last resort: The CB provides funds to troubled banks that cannot find any other sources of funds.

The CB performs important functions for banks including:

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Functions of the Central Bank

• To monitor the financial markets,

• Setting of reserve requirements for all financial institutions.

• To determine the terms and types of deposits in banks

The Central Bank performs important functions for banks including:

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The Central Bank Balance Sheet

Assets and Liabilities of the Federal Reserve System, June 30, 2003(millions of dollars)

ASSETS LIABILITIES

Gold $ 11,045 $593,031 Federal Reserve notes (outstanding)

Loans to banks 36,538 Deposits:

U.S. Treasury securities

550,314 20,359 Bank reserves (from depository institutions)

6,219 U.S. Treasury

All other assets 46,268 24,556 All other liabilities and net worth

Total $644,165 $644,165 Total

Source: Federal Reserve Bulletin, August 2003, Table 1.18.

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How the Central Bank Controls the Money Supply

• Three tools are available to the Fed for changing the money supply:

1. changing the required reserve ratio;

2. changing the discount rate; and

3. engaging in open market operations.

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The Required Reserve Ratio

• The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create.

• If the CB wants to increase the money supply, the CB can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.

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The Required Reserve Ratio

A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars)

PANEL 1: REQUIRED RESERVE RATIO = 20%

Central Bank Commercial Banks

Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

PANEL 2: REQUIRED RESERVE RATIO = 12.5%



Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans(+ $300)

$700 (+ $300)


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The Discount Rate

• The discount rate is the interest rate that banks pay to the CB to borrow from it.

• Bank borrowing from the CB leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

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The Discount Rate

The Effect On the Money Supply of Commercial Bank Borrowing from the CB (All Figures in Billions of Dollars)

PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE CB



Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320Note: Money supply (M1) = Currency + Deposits = $480.

PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE CB



Securities $160 $100 Reserves(+ $20)

Reserves(+ $20)

$100 $500 Deposits(+ $100)

Loans $20 $80 Currency Loans(+ $100)

$420 $20 Amount owed to Fed (+ $20)


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Open Market Operations

• Open market operations is the purchase and sale by the CB of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

• Open market operations is by far the most significant tool of the CB for controlling the supply of money.

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The Mechanics ofOpen Market Operations

Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars)

PANEL 1Central Bank Commercial Banks The Household

Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts

$80 Currency Loans $80 $5 Net WorthNote: Money supply (M1) = Currency + Deposits = $180. $80 Currency


Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities( $5)

$95 $15 Reserves ( $5)

Reserves ( $5)

$15 $95 Deposits ( $5)

Deposits ( $5)

$0 $0 Debts

$80 Currency Loans $80 Securities(+ $5)

$5 $5 Net Worth



Assets Liabilities Assets Liabilities Assets Liabilities

Securities( $5)

$95 $15 Reserves ( $5)

Reserves ( $5)

$15 $75 Deposits ( $25)

Deposits ( $5)

$0 $0 Debts

$80 Currency Loans( $20)

$60 Securities(+ $5)

$5 $5 Net Worth


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• An open market purchase of securities by the CB results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

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• An open market sale of securities by the CB results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

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• Open market operations are the CB’s preferred means of controlling the money supply because:

• they can be used with some precision,

• are extremely flexible, and

• are fairly predictable.

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The Supply Curve for Money

• Through open market operations, the CB can have the money supply be whatever value it wants.

The Money Supply and the Central Bank

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