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Principles of Macroeconomics

by: Grayce Heidenreich

Principles of Macroeconomics EC 202

Marketplace > North Carolina State University > Economcs > EC 202 > Principles of Macroeconomics
Grayce Heidenreich
GPA 3.84

O. Movchan

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O. Movchan
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This 4 page Class Notes was uploaded by Grayce Heidenreich on Thursday October 15, 2015. The Class Notes belongs to EC 202 at North Carolina State University taught by O. Movchan in Fall. Since its upload, it has received 13 views. For similar materials see /class/223922/ec-202-north-carolina-state-university in Economcs at North Carolina State University.


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Date Created: 10/15/15
NCSU EC 202 PRINCIPLES OF MACROECONOMICS Department of Economics Summer 2008 CHAPTER 13 Money Banks and the Federal Reserve System 1 What Is Money and Why Do We Need It Money is any asset that people are generally willing to accept in exchange for goods and services or for payment of debts An asset is anything of value owned by a person or firm The invention of money started from barter economies which were goods and services traded directly for other goods and services 0 For a barter trade to take place between two people each person must want what the other one has known as double coincidence of wants 0 A good used as money that also has value independent of its use as money is called a commodity money 0 By making exchange easier money allows for specialization and higher productivity Money should fulfill four functions 0 oney serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services 0 Money serves as a unit ofaccount when each good has a price in terms of dollars 0 Money serves as a store of value when value is stored such as stock bonds real estate and valuable items 0 Money serves as a standard of deferred payment in borrowing and lending There are five criteria that make a good suitable to use as a medium of exchange 0 The good must be acceptable to that is usable by most traders o It should be of standardized quality so that any two units are identical 0 It should be durable so that value is not lost by spoilage o It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported o The medium of exchange should be divisible because different goods are valued differently Commodity money eg gold meets the criteria for a medium of exchange but its value depends on its purity Fiat money is a paper currency that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bankfor gold or some other commodity money Today our money has value not because of the materials used to make it but because people have faith and confidence in its acceptability In Argentina recently the public lost confidence in the official currency the peso and people resorted to using barter or US dollars instead of using Argentina s official money When people lack confidence in money there are serious macroeconomic consequences 2 How Do We Measure Money Today In the US the Federal Reserve System has developed several different definitions of the supply of money The different definitions of money are based upon the different functions of money The current definitions of money are M1 is the narrowest definition ofthe money supply and includes I All the paper money currency and coins that are in circulation what is not held by banks or government I The value of all checking account balances at banks I The value of travelers checks M2 is a broader definition of the money supply and includes I Everything that is in M1 I Savings account balances I Small denomination time deposits eg certificates of deposit CDs Earanees m money market oeoosrt accuunts m oanks Nonrnsmononar money markenon M3 rs a broader meorom or Exchange and sinus yaroe ano mdudes Everythmg that rs m M2 Largerdenummatmnume oeoosrts nsmononar money markenono snares What39s Measured 514 lelllon Narrow Medium M or Exchange 65 lelllan 1 M2 Broader Medrum 59a TIIIIIon uf Exchange Broader Medmm Mai or Exchange am Store 0 Value Tnere are Wu key pumts aoooune money sooory 0 w 0 Because oaranees m eneekrng accuunts are mduded m the money supp y banks may an mpunant rore m the oroeess byvmmh the money sooory rnereases ano oeereases Credrt earos are nut mduded m the m n ow o an m ar eonsroereo me ereort earo 3 How Do Banks Create Money Eqmty on tne ngnt n the U 5 eneekrng accuunt oeoosrt oaranees are abuut aw of M1 cneekrng accuunts at banks are uvvned oy huusehu ds busmess nrms and the guvemment One way tn uuk at bank uperatmns rs tn uuk at a bank s oaranee sheet and W nPV Wrmh the orrrerenee between assets and habmues By de nmuny than Asset Liabilities NetWonh Tne key assets on a bank s oaranee sheet are rs reserves man and nororngs or securmes soon as U 5 Treasury oms Banks oo nut keep 3 thew oeoosrts as easn Banks keeo onry a framun or thew oeoosrts as vau t easn Mos oanks r u y u a cum a n Hn n Vamt easn pms deposrts aune Fed are named tne bank s reserves A m percent A sneet The ratio of the amount of deposits created by banks to the amount of new reserves is called the simple deposit multiplier 1 Sim le de osit multi lier 7 P P P RR 1 Change 1n checklng account deposns Change 1n bank reserves X E For example if the change in reserves was 5000 and a reserve requirement ratio RR is 10 a simple deposit multiplier equals 10 10101 and the change in deposits is A D 5000 50000 Whenever banks gain reserves they make new loans and the money supply expands Whenever banks lose reserves they reduce their loans and the money supply contracts 4 The Federal Reserve System The Federal Reserve System or the Fed is the central bankforthe US When many depositors simultaneously decide to withdraw their money from a bank there is a bank run 0 If many banks experience runs at the same time the result is a bank panic o A central bank like the Federal Reserve in the US can help stop a bank panic by acting as a lender of last resort With the intention of putting an end to banking panics in 1913 Congress passed the Federal Reserve Act setting up the Federal Reserve System which began operation in 1914 Congress divided the country into twelve Federal Reserve districts each with a Federal Reserve Bank which provides services to banks in that district Also created was a group called the Board of Governors to oversee the individual Federal Reserve banks The Board of Governors has seven members appointed by the President to serve a fourteenyear term The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives is known as the monetary policy which uses three tools A The Federal Open Market Committee FOMC or the Federal Reserve committee is responsible for open market operations and managing the money supply The FOMC of the Fed through the Federal Reserve Bank of New York buys and sells US government securities to change the supply of money When the Fed buys securities the payment for the securities puts more reserves in the banking system and causes the money supply to increase When the Fed sells securities the payment for the securities by the public takes reserves out of the banking system and causes the money supply to fall Open market purchases create new reserves in the banking system When banks make new loans with these new reserves the level of deposits and the money supply will increase 0 The buying and selling of Treasury securities is called open market operations 0 There are three reasons the Fed conducts monetary policy principally through open market operations I The Fed initiates open market operations it completely controls their volume I The Fed can make both large and small open market operations I The Fed can implement its open market operations quickly with no administrative delay or required changes in regulations B The loans the Fed makes to banks are called discount loans and the interest rate it charges on the loans is called the discount rate Banks can borrow from the Fed Loans from the Fed to banks are called discount loans and occur at an interest rate called the discount rate The discount rate is set by the Fed at the FOMC meetings The Fed serves as a lender of last resort for banks and is willing to lend to banks when they cannot borrow elsewhere This function can help stop bank panics and bank runs C When the Fed reduces the required reserve ratio it converts required reserves into excess reserves Using the abovementioned three tools the Fed has substantial influence over the money supply but that influence is not absolute There are two other actors that also influence the money supply in practice the nonbank public and banks US banks only keep about 10 percent of their deposits on hand as reserves Most banking systems are fractional reserve banking systems in which banks keep less than 100 of their deposits as reserves The Feds reserve policy determines the fraction of deposits banks must keep These reserves are kept in the bank as vault cash or kept as deposits at the Fed Reserve requirement ratios change infrequently 5 The Quantity Theory of Money In the early twentieth century lrving Fisher an economist at Yale formalized the connection between money and prices using the quantity equation The equation states that the money supply M multiplied by the velocity of money V equals the price level P multiplied by real output Y o The velocity of money is the average number of times each dollar in the money supply is used to purchase goods and services included in GDP 0 The quantity theory of money is a theory of the connection between money and prices that assumes that the velocity of money is constant MXVPgtltY V is defined as the velocity of money which measures the average number of times a dollar is used to purchase a final good or service and is calculated as V PYM From the quantity theory of money equation it follows that Growth rate in M growth rate in V growth rate in P or the inflation rate growth rate in Y real GDP growth rate Rearranging terms gives inflation growth rate in M growth rate in Y growth rate in V lrving Fisher stated that when velocity is constant the growth rate of velocity will be zero which led to the following predictions o If the money supply grows at a faster rate than real GDP there will be inflation o If the money supply grows at a slower rate than real GDP there will be deflation decline in prices o If the money supply grows at the same rate as real GDP the price level will be stable and there will be neither inflation nor deflation Very high rates of inflation are known as hyperin ation It is caused by central banks increasing the money supply at a rate far in excess ofthe growth rate of real GDP The link between rapid money growth and high inflation was evident in the experience of Argentina during the 1980s


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