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by: Mr. Tito Legros


Mr. Tito Legros
Texas A&M
GPA 3.74

Michael Nelson

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Michael Nelson
Class Notes
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This 15 page Class Notes was uploaded by Mr. Tito Legros on Wednesday October 21, 2015. The Class Notes belongs to ECON 203 at Texas A&M University taught by Michael Nelson in Fall. Since its upload, it has received 29 views. For similar materials see /class/225828/econ-203-texas-a-m-university in Economcs at Texas A&M University.




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Date Created: 10/21/15
Money Banks and the Federal Reserve System l A Consider the purchase of a good with money Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts Assets Anything of value owned by a person or a firm Money vs Wealth 1212010 1212010 39 1 In a world without money how would trade occur What s so bad about that I Barter requires a double coincidence of wants Suppose that you want a laptop computer and you have a bicycle to trade Not only do you have to find someone with a laptop computer that you want but that person must Consider a money economy on the other hand You can sell your bicycle to anyone who wants it They pay you with You then use this money to pay the laptop owner for her computer Thus you can specialize in doing one ortwo activities earn money and use this money to buy 39 1 Four Functions of Money 1 Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services 2 Unit ofAccount Consider a barter economy with 4 goods lemons shoes cars and chairs What is the price of a car 3 Store of Value Money allows value to be stored easily If you do not use all your accumulated dollars to buy goods and services today you can hold the rest to use in the future Do other assets store value also 1212010 If some assets store value better than money then why do people hold any money at all Liquidity is the ease with which an asset can be converted to medium of exchange When people decide in what forms to hold their wealth they have to balance the liquidity of each possible asset against the assets usefulness as a 4 Money is useful because it can serve as a standard of deferred Qaymenfin borrowing and lending How does inflation affect the functions of money High inflation limits the ability of money to effectively serve as 39 i The Kinds of Money Definition of commodity money money that takes theform of a commodity with intrinsic value Definition of fiat money money without intrinsic value that is used a 5 money because of government decree Measuring Money in the US Economy There are two common measures of the amount of money often called the money stock in the US economy M1 and M2 M1 includes the most liquid items M2 includes M1 plus some El M1 The Narrowest Definition of the Money Supply includes 1 Currency which is all the paper money and coins that are i circulation where 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 although this last category is so small less than 7 billion in May 2007 we will ignore it in our discussion of the money supply M2 A Broader De nition of the Money Supply includes M1 plus savings account balances smalldenomination time deposits CD5 and some other money market deposits Ii El Learning Objective 132 M1 The Narrowest Definition of the Money Supply FIGURE 131 Me asLlring ft39heE Money SupplyA llll Ma y m K Tlavelews checks mutual lund shares 56 5 billion 5369 a hilllan Ml 513533 billlon Small llme sposlls smug billl39u cunency 755 bllllon sawgs deposils 3555326 bllllarl la M1 513639 billion 5 M2 572412 blllion 1212010 How do banks create money Reserves Deposits that 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 HR 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 Bank Balance Sheets FIGURE 132 Learning Objective 133 BalanceSheettorWachovia Bank Decemberst 2006 Ll ElLITIEE AND STOCKHOLDERS39 AEBEI39B Ill HILLIDIIS EG UlTY IN MlluJQN Hesewss 32749 Uspaslts 40 155 Luans 416198 Swanterm borrowi rig w 020 Derer M111 other banks 2167 Lowgrterm deb 158594 Securities 108819 other llabl ties 41333 Build39ngs am Equipment 6141 Total Iiab lil as 637 105 Other assets 140647 Stockholders equ by 716 Total assets 07121 Total Labquotth and stmkholdere39 equrly 70 121 1212010 1212010 LeameObiec ve 133 r Using TAccounts to Show How a Bank Can Create Money Assets Liabilities Reserves 1000 Deposits 1 000 Your deposit of 1000 into your checking account increases Wachovia39s assets and liabilities by the same amount LeameObiec ve 133 L Using TAccounts to Show How a Bank Can Create Money Assets Liabilities Reserves 1000 Deposits 1000 Loans900 Deposits 900 2 Wachovia has increased the money supply by 900 1 By loaning out 900 in excess reserves 1212010 LearniHQObiective133 Using TAccounts to Show How a Bank Can Create Money Wachovia Assets Liabilities Fleserves100 Deposits 1000 Loans900 2 v and me increase in Wachuvla Bank deposils lalls by 900 lo 1 000 1 When the 900 check than was deposited in a FNC acouunl amVeS in be cleared the increase in Wachovla s iesewes shown in me previous Taocoum lalls by PNC Bank DD 5900 o 51 Assets Liabilities Reserves 900 Deposits 900 l deposils bolh increase by 900 LeameObiec ve 133 Using TAccounts to Show How a Bank Can Create Money PNC Bank Assets Liabilities Reserves 900 Deposits 900 Loans 810 Deposits 810 By making an 810 loan PNC has increased both its loans and ils deposits by 810 Using TAccounts to Show How a Bank Can Create Money BANK INCREASE IN CHECKING ACCOUNT DEPOSITS Learning Objective 133 Wachovia PNC Third Bank Fourth Bank Total Change in Checking Account Deposits 1000 900 09x1000 810 09x900 729 09x810 10000 Note that the initial deposit multiplies through the banking system SimQe dersit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves 1212010 1212010 39 The Simple Deposit Multiplier vs the RealWorld Deposit Multiplier Our multiple deposit creation story made 2 assumptions which are not necessarily true in the realworld 1 We assumed that banks do not have any excess reserves If they do hold excess reserves the realworld multiplier will be 2 We assumed that the whole amount of each check is deposited and that the public does not hold any amount of a check as currency If the public does hold part of a check as currency the realworld multiplier will be Despite these complications let s not lose sight of the forest forthe trees Whenever banks gain reserves they make new which causest e Whenever banks lose reserves they reduce their which causes the You can think of reserves in the banking system as fuel that allows banks to create 1212010 39 1 The US banking system is a fractional reserve banking system This is a banking system in which banks keep less than 100 percent of deposits as reserves Such systems are somewhat susceptible to bank runs in which many depositors simultaneously decide to withdraw money from a bank One bank can likely sustain a bank run as it can borrow money from In the case of a bank Qanic however many banks simultaneously experience bank runs In this case the entire banking system may This possibility is one reason that we have a central bankin the US Central banks help reduce the risk of a bank panic 39 i The US Federal Reserve Bank aka the Fed was created in 1913 as our central bank That is it was created to oversee the banking system and regulate the quantity of money in the economy The primary envisioned role of the Fed was that of lender of last resort to troubled banks 0 Positive aspect ofthis role 0 Negative aspect of this role i The Federal Reserve System The Organization of the Federal Reserve System FIGURE 133 Kansas Clly Cleveland 2 39 aoslnn SL Louis 39 El of the Federal Reserve Svstem 1 12 District Federal Reserve Banks 2 The Board of Governors G 7 Members appointed by the President of the US 0 One of these 7 members is appointed as Chairman of the Fed 3 The Federal Open Market Committee FOMC meets 8 times per year to discuss monetary policy a 12 members 7 B of G members plus 5 Presidents of District Banks 1212010 39 1 Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives The tools of monetary policy are 1 Open Market Operations are the buying and selling of Treasury securities bonds by the Federal Reserve in order to control the money supply C If the Fed wishes to increase the money supply it engages in open market D If the Fed wishes to decrease the money supply it engages in open market 39 i 2 Discount Policy C Discount loans are loans the Federal Reserve makes to banks The Fed charges these banks interest This interest rate is called the discount rate loa which banking system which does what to the money supply 3 Reserve Requirements are set by the Fed Ci When the Fed reduces the required reserve ratio it converts to required reserves in i lfthe Fed lowers the discount rate it encourages banks to take 39 mount of reserves in the 1212010 1212010 39 The Quantity Theory of Money In the early twentieth century Irving Fisher an economist at Yale formalized the connection between money and prices using the quantity equation Where M Money Supply V velocity of money P price level and Y Real output The velocity of money is the average number of times each dollar is used to The quantity equation is an identity We can rewrite the quantity equation as In a recent year in the US we had the following values A key question concerning whether or not the velocity of money is constant over time The evidence says that there are fluctuations in the velocity in the short run but it is fairly constant in the 1212010 Mathematically an equation whose variables are multiplied together is equal to the an equation where the growth rate of these variables are added together Thus we have Or If V is stable in the long run then its long run growth rate is zero and we have 39 1 Inflation rate A in Money Supply A in Real Output Therefore if I Money supply grows faster than output we have I Money supply grows slower than output we have I Money supply grows at the same rate as output we have Very high rates of inflation are termed What causes hyperinflation 1212010 39 Almost all 39 39 quot followthe same pattern The government has a high level of spending and its ability to raise tax revenue is The government s ability to borrow funds is As a result it turns to printing money to pay for its spending The large increases in the money supply lead to large amounts of How does this end


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