What Is Money and Why Do We Need It?

Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts.

Asset Anything of value owned by a person or a firm.

What Is Money and Why Do We Need It?

The Functions of Money

• Medium of exchange: buy stuff with money

No need to barter

• Unit of account: post prices/keep books in money terms

• Standard of deferred payment: need money to pay debts• Store of value

Hold money on chance prices of other assets fall

What Can Serve as Money?

Criteria for an asset to be a medium of exchange:

1 It must be acceptable to most people.

2 It should be of standardized quality.

3 It should be durable.

4 It should be valuable relative to its weight.

5 It should be divisible.

Currency is fine… “fiat money”

Checking account balances are just as good.

Electronic “money” is even better.

Precious metals serve when confidence falters.Commodity money.

M1: The Narrowest Definition of the Money Supply

M1 includes means of payment:

1 Currency: paper money and coins in circulation.

• “in circulation” means not held by banks or the government

2 The value of all checking account deposits at banks

3 The value of traveler’s checks

How Is Money Measured in the United States Today?

1 Because balances in checking accounts are in the money supply, banks play an important role in the way money supply increases and decreases.

What about Credit Cards and Debit Cards?You haven’t paid until you write a check to your bank.

M1: The Narrowest Definition of the Money Supply

How Is Money Measured in the United States Today?

Figure 25-1Measuring the Money Supply, July 2009

The Federal Reserve uses two different measures of the money supply: M1 and M2.M2 includes all the assets in M1, as well as the additional assets shown in panel (b).

Money is an asset, like stocks and bonds and real estate. Unlike these other assets, however, money pays no interest and promises no yield. Why, then, do people hold money as a store of value?

A) You need money to buy stuffB) You need money to pay off your debtsC) It’s good to hold some of your wealth in money, particularly if you think the prices of other asset will fall.D) All of the above

How Banks Create Money in a Fractional Reserve Banking System

Legal Reserves Funds a bank keeps as cash in its “vault” or on deposit with the Federal Reserve.

Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits.

Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves.

Excess reserves Reserves that banks hold over and above the legal requirement.

Banks buy interest yielding assets with deposits they don’t keep in reserves:• Gov’t securities, loans to households and firms

Balance Sheet for a Large Bank, December 31, 2010

How Banks Create Money

If the required reserve ratio is 10%, Wachovia now has $900 in excess reserves

PNC now has excess reserves of $810. It can extend a loan and create a deposit of $810.

How Banks Create Money

BANK

INCREASE IN CHECKING DEPOSITS

Wachovia $1,000

PNC + 900 (= 0.9 x $1,000)

Third Bank + 810 (= 0.9 x $900)

Fourth Bank + 729 (= 0.9 x $810)

. + •

. + •

. +

Total Change in Checking Account Deposits =$10,000

d. What is the maximum possible increase in deposits in the banking system if all banks lend to the limit and no currency is held by the public?

Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.

RR1 multiplierdeposit Simple

1Change in checking account deposits Change in bank reserves x RR

Change in required reservesfor a bank and for the

banking system = RR x Change in deposits

The Simple Deposit Multiplier versus the Real-World Deposit Multiplier:• Not everything that one bank lends gets deposited in other banks.

– Much leaks out as currency holdings rather than deposits.• And banks may not lend to full extent the can…they hold excess reserves.

Real world deposit multiplier is less than the simple multiplier.

The deposit multiplier we just developed and the expenditure multiplier we studied before are the same thing.

A) True B) False

The deposit multiplier we just developed and the expenditure multiplier we studied before are the same thing.

A) True B) False

False: The deposit multiplier multiplies an injection of additional reserves into the banking system into a larger increase in bank loans, bank deposits and Money Supply (Currency + Deposits).The expenditure multiplier multiples an increase in autonomous spending into a larger increase in total output, total income, and total spending.

The Functions of a Modern Central BankThe Banker’s Bank:

Lender of last resort in crises• Bank run: When many depositors rush to withdraw money at

the same time...They “run” to get to the cashier.• Silent run: Major creditors don’t turn over their loans to a

bank.• Bank panic: Many banks

experience runs at the same time.Operates clearing system for interbank payments.Oversees financial intermediaries - ensure their soundness. - ensure public confidence

The Government's Bank:– Manages government transactions.– Controls availability of money and credit.

The Federal Reserve SystemThe Organization of the Federal Reserve System

Federal Reserve Districts

Federal Open Market Committee: Board of Governors + District BankPresidents meet 8 times a year to set policy. All presidents attend the FOMC meetings but they take turns voting (FRBNY guy always votes).

Board of Governors:Seven Governors nominated by Pres-ident and confirmed by Senate for 14 year terms. The Chair has a renewable 4 year term.

Which of the following people vote on monetary policy at the Federal Open Market Committee (FOMC) meetings?a. The seven members of the Federal Reserve’s Board of

Governors.b. The president of the Federal Reserve Bank of New York.c. Four presidents from Federal Reserve banks other than the

president of the Federal Reserve Bank of New York (rotating basis).

d. All of the above.

How the Federal Reserve Manages the Money SupplyMonetary policy The actions the Federal Reserve takes to manage the money supply and interest rates in pursuit of economic objectives.To manage the money supply, the Fed uses three monetary policy tools:

1 Open market operations: Fed buys and sells gov’t securities

• Federal Open Market Committee (FOMC) sets target federal funds rate.

• “Federal funds” are reserves that banks borrow and lend to each other.

• Fed buys bonds to increase the supply of reserves and lower the fed funds rate: BEST – BUY EASE SELL TIGHTEN.

2 Discount policy: Fed lends to banks @ discount rate

injects reserves into banking system directly

3 Reserve requirements: lowering reserve requirement converts required reserves to excess reserves that banks can lend

Two other actors—the nonbank public and banks—also influence the money supply.

Multiple Creation of Money and CreditFed buys something … MB up

A bondA bank IOU

Seller deposits proceeds in Bank AMoney supply increases

Bank A’s deposits @ Fed increaseBank A now has more reserves

Bank A holds reserves against its new deposit (required + excess)

Bank A makes loan to customerBorrower now has more deposits ... Money has just been created

Borrower buys somethingSeller holds onto currency and deposits the rest in its Bank B

Bank B’s deposits @ Fed increase:

The Fed’s Balance Sheet Owns Owes .Gold, Forex Federal Reserve Notes

• Currency in CirculationVault Cash ReservesBank IOUs Bank Deposits @ Fed

(Discount loans) Bank A Bank B :Securities Gov’t Deposits

Gov’t Bonds MBSs Miscellaneous

Monetary Base High Powered= MB Money = H = MB

Note: MB = Currency + Bank Reserves = Cu + RMs = Currency + Demand Deposits = Cu + D

The Fed uses three monetary policy tools. Which of the following is not one of those tools?a. Open market operations.b. Discount policy.c. Reserve requirements.d. Federal funds rate setting.

The “Shadow Banking System” and the Financial CrisisThe banks we have been discussing are commercial banks, who accept funds from depositors and lend those funds to borrowers.In the past 20 years, important developments have occurred in the financial system:• Banks have begun to resell many of their loans rather than keep them

until they are paid off.• Financial firms other than commercial banks, e.g., less-regulated

investment banks, MMMFs, hedge funds, have become sources of credit to businesses. Banks have faced increased competitive pressure.

• Banks and these non-bank financial firms increasingly rely on very short-term liabilities, e.g., overnight repurchase agreements, to finance their long-term, income-earning assets, e.g., loans.

• Loans (mortgage loans, student loans, credit card loans,...) have been bundled together with shares in these bundles sold off as securities (securitization).

Securitization The process of transforming loans or other financial assets into securities.

The Process of Securitization

(a) Securitizing a loan (b) The flow of payments on a securitized loan

As the trigger of the crisis, problems in the U.S. housing market led to a myriad of troubles in the financial system:

•Mortgage-backed securities lost value; their investors suffered heavy losses.

• Many investment banks and other financial firms without deposit insurance that had borrowed short term and invested long term had to sell their holdings of securities fire sale.

• In 2008, the failure of the investment bank Lehman Brothers set off a panic securitization and interbank lending nearly ground to a halt.

• A wave of withdrawals from money market mutual funds disabled their role as buyers of corporate commercial paper.

• As banks and other financial firms sold assets and cut back on lending to shore up their financial positions – deleveraging – the flow of funds from savers to borrowers was disrupted and the resulting credit crunch significantly worsened the recession.

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

A “Global Saving Glut”

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt DeflationSpiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Unleashed

Responses: No Bank Left BehindLender of Last Resort / Spender of Last Resort

Tax Rebate $124 bil.Fed Fund Rate CutsFannie/Freddie $200 bil.Bear-Stearns $29 bil.AIG $174 bil.Fed “Facilities”Primary Dealer Credit Facility (PDCF) $58 bil.Treasury Security Loan Facility (TSLF) $133 bil.Term Auction Facility (TAF) $416 bil.Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.Money Market Investor Funding Facility (MMIFF) $540 bil.More Fed Fund Rate Cuts … Hold At ~0%Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.Term Asset-Backed Securities Loan Facility (TALF) $200 bil.Emergency Economic Stabilization Act/TARP $700 bil.

Government LoansGovernment Equity

Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act

TARP IIStress Tests

Connecting Money and Prices: The Quantity Equation

M × V = P × Y

The Quantity Theory of Money

Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

MY x PV

The Quantity Theory Explanation of InflationWe can transform the quantity equation from:

Growth rate of the money supply + Growth rate of velocity

= Growth rate of the price level (or inflation rate)

+ Growth rate of real output

Y x P V x M to:

If velocity is constant, then the growth rate of velocity is zero. This allows us to rewrite the equation one last time:

Inflation rate = Growth rate of the money supply − Growth rate of real output

a. 3%b. 6%c. 9%d. 18%

The German Hyperinflation of the Early 1920s

Makingthe

Connection

During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.

K e y T e r m s

AssetBank panicBank runCommodity moneyDiscount loansDiscount rateExcess reservesFederal Open MarketCommittee (FOMC)Federal Reserve SystemFiat moneyFractional reserve banking system

M1M2Monetary policyMoneyOpen market operationsQuantity theory of moneyRequired reserve ratioRequired reservesReservesSimple deposit multiplierVelocity of money