Tuesday, July 22, 2008



See opening quote, page 290, by Milton Friedman.

We will now switch from fiscal policy to monetary policy in the next two chapters. We first look at Money and the Banking System and then focus on monetary policy in the next chapter. Fiscal policy is conducted by Congress and the President (or Parliament and Prime Minister), Monetary policy is conducted by the Central Bank (Federal Reserve Bank), which is a "quasi-governmental" institution that supervises the banking system and regulates the supply of money in the economy.


Money is what we use to make payments for our debts, goods, services, products, and financial assets. But unlike gold or silver money, modern money has no real value - it is just green paper with no intrinsic value - but everyone wants more of it. Why? Because Money is an asset that performs three very important functions in the economy:

1. Medium of exchange - money is an asset used as a means to make final payment. We use dollars to pay for goods and services. Increases efficiency of trade and exchange. Without money in the economy, we would have a barter economy, where we would trade goods for goods, or services for goods, etc. instead of money for goods or services. Barter is inefficient because it relies on the "double coincidence of wants."

For example, to get food, you would have to find a farmer who has what you want and you would have to have something the farmer wants. To get medical service, the farmer would have to find a doctor who wants a cow or milk, etc. Barter is extremely inefficient.

Compared to barter, money is extremely efficient. The farmer can sell a cow for money, and then go out and buy whatever he/she wants with the cash - medical services, electricity, etc. Money eliminates the "double coincidence of wants" and makes the economy operate much more efficiently.

When is barter efficient? - baseball card convention, coin/stamp trading, etc. Market for dating/marriage. Russia - Pepsi/Stolys. To avoid high taxes. Or during hyperinflation.

2. Money is used as a unit of account. In the US, everything is priced in dollars, so we have a standard unit of measurement (dollars) to measure value in the economy, just like we use standard units to measure distance (yards, feet, miles, kilometers, etc). Money is a measuring rod of value. By having a common unit of account (measurement), we can compare prices/values easily since economic value is stated in dollars.

Another reason that a barter economy is inefficient - there is no standard unit of measurement. Makes comparison shopping very difficult.

3. Store of value/wealth - money is used as a financial asset to transfer purchasing power from the current period to a period in the future. You can put $100 bills under your mattress and transfer purchasing power to a later period (next year, ten years from now, etc.). You can also store wealth in stocks, bonds, mutual funds, real estate, etc., but money has some advantages:

Advantages of money as an asset (vs. stocks, bonds, real estate):
a. cash is more liquid than any other asset - (Liquidity: the degree to which an asset can be converted to cash quickly without loss of value.) Stocks and bonds are not as liquid as cash.
b. cash has a fixed nominal value ($100 bill will always be worth $100) - unlike stocks/bonds/real estate which could fluctuate in value.
c. cash is anonymous

Disadvantages of money as an asset:
a. pays no interest, and will lose value (purchasing power) when inflation is positive
b. cash is anonymous

In most cases, the same currency is used for the unit of account, the medium of exchange and a store of value. In U.S., we price everything in dollars, we use dollars for final pmt. and we use dollars to store wealth. Not always the case:
a. Israel - $ was used as the unit of account in many shops to avoid "menu costs" (costs of changing price tags, menus, catalogs, etc) during periods of high inflation when prices might be changing daily. Israeli shekl was still used as the medium of exchange, based on the daily $/shekl ex-rate.
b. Russia, S. America, etc - local currency is not used as a store of value, people hoard US dollars.
c. Euro, SDRs - unit of accounts without a medium of exchange. Basket of currencies, which are quoted daily in the WSJ as ex-rates.


Commodity money has been used throughout history until this century - gold, silver, copper, tobacco, beads, salt, etc. We were on a limited form of commodity money until 1970, when all silver was removed from the half dollar. Silver was removed from quarters/dimes in 1964.

Advantage of commodity money - limited supply of precious metal can prevent inflation and stabilize the price level. Exception: tobacco.

Disadvantage: uses up scarce resources. High opportunity cost. Gold/silver have other uses besides coins.

Fiat money = money which has no intrinsic value and is not backed by a commodity. Paper money, metal coins and checks are now used in U.S. and this is fiat money. Fiat money means that the government has issued a decree of fiat, that US dollars are legal tender - for all debts, public and private. Illegal for a bank or private company to issue legal tender.

Money's source of value is related to: a) the fact that it is generally accepted as payment for real goods and services and b) how much it will buy (purchasing power).

Like other assets or goods, money's value is directly related to the supply of and demand for dollars. The greater the supply of dollars, the less valuable a $1 bill is. More money and higher prices reduce the purchasing power of money. Money's value (purchasing power) is inversely related to the supply of dollars and the price level. If money grows faster than the rate of real output, prices will rise, inflation will rise, and the value of money will fall. Inflation is caused by "too much money chasing too few goods." "Inflation is always and everywhere a monetary phenomenon."

Extreme case - hyperinflation. Money becomes worthless. Example: 1922-23, German govt. printed so much money that inflation was 250% per month. It cost 80B marks for an egg and 200B marks for a loaf of bread. Workers picked up wages in suitcases. Shops closed at lunchtime to change price tags. In recent times, Argentina, Brazil, Israel, Russia, etc. have had periods of hyperinflation.


How do we measure money? For the central bank to regulate the money supply (MS), they have to know how much money is in circulation. There is no clear definition of exactly what money is. For example, you have $1000 cash, that is definitely money, but what if you have a $1000 Certificate of Deposit (CD) or a $1000 T-bill? You can't use the CD or T-Bill to pay for goods and services, but they fit the definition of money as a store of value. Economists and the FRS use three arbitrary measures of money - M1, M2 and M3 - to account for the different functions of money.

M1 - most narrow definition of money. M1 measures those forms of money that can be used as a medium of exchange - money used for final payment. Only three ways to make final pmt.: pay with cash, write a check or use a traveler's check. There are two different types of checking accounts:
a) demand deposits, which are non-interest bearing checking accounts. Most businesses have demand deposit checking accounts.
b) other checkable deposits, that are interest-bearing personal checking accounts. Usually limits/restrictions to get interest, like maintaining a minimum account balance to get interest.

See page 294. M1 = $1203B, little over $1T (vs. GDP which is about $11T) . M1 is about 49% currency ($586B) and about 51% checking accounts ($609B), small fraction (less than 1%) in traveler's checks.

M2 - broader definition of money than M1. M2 includes everything in M1 plus other forms of money, all interest bearing financial assets. M2 includes money used as a store of value. M2 includes all savings accounts, small CDs, money market mutual funds, short-term overnight deposits.

Money market mutual funds (retail) - act like checking accounts, available at investment banks like Merrill-Lynch, investments in short-term money market instruments like 3 month T-bills for example. Operates like a mutual fund, pooled assets, but you have check-writing privileges like a checking account.

M2 = $5.48T, about 4.5x the amount of M1, or more than $4.2T larger. Reflects the fact that most people keep as much money as possible in interest-bearing accounts.

M1 (money as med. of exchange) and M2 (money as store of value) are the most important measures of the MS, although there are other measures like M3 (broader than M2) and L (broader than M3). We focus in this course on just M1 and M2.


Money is a financial asset that provides us with current or future purchasing power. Credit cards are not part of the money supply because they are just convenient ways to make a loan. You are actually borrowing money from the bank that issued the card, and payment is deferred until you make pmt. to the credit card issuer. Money is an asset that represents current or future purchasing power. Credit purchases do not technically represent purchasing power, they represent consumer credit, a way to defer final payment. Credit cards are not counted as part of the MS, but do affect the money supply, since having the convenience of plastic reduces our average cash balances, decreases our demand for money.


We will now focus on the Banking Industry and look at the role of the banking industry in the process of money creation. Banking industry operates under the jurisdiction of the Federal Reserve System, the central bank of the U.S., although not all banks actually belong to the FRS. FRS supervises the banking system, sets banking requirements, processes checks and sets the nation's monetary policy.

Banks are in the process of Financial Intermediation, acting as financial intermediaries (middlemen) to bring together people who want to save for the future (savings = deferred consumption) and people who want to borrow money now for current consumption (buy a car) or current investment (business borrowing). We make deposits in checking accts/svgs. accts, which provides the bank with a source of funds, get paid 1-5% interest. The bank then uses those funds to make loans to borrowers for cars, home improvement, mortgages, credit cards, student loans, etc. at 8-20% interest. Bank profits are the spread between interest paid to depositors and interest received from borrowers.

Banks can be set up in several different ways -
State charter vs. National charter - Dual Banking System
Commercial Banks vs Investment banks (Merrill-Lynch)
S&L charter vs. Commercial bank vs Credit Union

Most commercial banks now are very similar - offer checking, savings, etc. When we talk about the "banking industry" we are referring to all the commercial banks, S & Ls, and credit unions in the U.S.

See page 298 for a consolidated balance sheet for the Commercial Banks. The majority (2/3) of a bank's source of funds ($4261B) comes from checking accounts (transaction deposits) and savings accounts and time deposits (CDs). Most of that money gets loaned out - $3964B, or invested - used to purchase securities ($1477). Only $41B is actually totally liquid - available immediately to meet cash withdrawals - $32B in vault cash (currency) and $9B on reserve at the Fed.

This illustrates that we operate under a Fractional Reserve Banking system. Banks are only required to maintain a small amount of reserves against their deposits (about 1% in this case). Vs. 100% reserve banking where a bank would be required to hold 100% of deposits in liquid reserves.

Required Reserves = minimum amount of reserves required by the FRS, to be held as vault cash and on deposit at the FRS. All banks are required to have an account with the FRS. In 2001, there was only 1.14% in reserves, against deposits ($41B/$4261B).

Required reserves are based on required reserve ratios - percentage requirement based on the type of deposit. See page 304 for current required reserve ratios.

Total Reserves = Required Reserves + Excess Reserves.

Excess reserves are reserves over and above the min requirement. Banks try to minimize reserves, ideally have 0 excess reserves, because Reserves pay 0% interest. Non-interest bearing asset for the banks.

Banks operate under what might seem like a very risky system - what is there is a run on the bank. Bank could not meet the demand for withdrawals if all depositors showed up at once. FDIC provides deposit insurance to stabilize the banking system. It was established in 1933 after 9000 banks failed. FDIC insures deposits up to $100,000. Banks pay a small premium based on their deposits and FDIC pays off depositors when a bank fails and can't pay its depositors.


Fractional reserve system allows money to be created through the banking system, there is an expansionary effect that takes place.

See page 300, Exhibit 3.

Example: Suppose that you found $1000 hidden in the basement. Or we could assume that the Fed had expanded the money supply by $1000. What effect would that have on M1? Assume that the required reserve ratio is 20%.

Step 1 - You take the $1000 and deposit it in your checking account at Bank A. Bank A's reserves increase by $1000 and demand deposits (D) increase by $1000. The bank is only required to keep 20% or $200 on reserve, so it has excess reserves of $800.

Step 2 - They then loan out the $800 to somebody that wants to buy a car. The bank has now created $800 in new money (demand deposit). The process starts all over again. When the $800 gets spent it becomes $800 in new reserves at a new bank - Bank B. The bank is only required to hold 20%, or $160, so it lends out a new loan for $640, and increases the demand deposits by $640.

Step 3 - The person with the loan spends the $640 on another car, or something else, and the process starts all over again when the $640 gets into a new bank - Bank C.

The deposit expansion process continues until there is $5000 of new demand deposits and M1. So, starting with $1000 of new money, the MS/M1 grew by 5x that amount.

The potential deposit multiplier (DM) is equal to: 1 / (required reserve ratio). In this case it was:

DM = 1 / .2 = 5x, meaning that for every $1 of new money created, the money supply will eventually increase by 5x that amount, or $5.

If the reserve requirement were .1, the DM would be 1 / .1 = 10x. As we will see later, one of the tools of monetary policy is the reserve requirement. If the FRS LOWERS the required reserve ratio (RRR), MS will go up, because the DM will go up. If FRS RAISES the RRR, the DM will fall, and the MS will fall.


In reality, the actual DM will be less that the full potential amount, for example, of 5, for two reasons:

1. Cash leakages - if people hold cash, outside the banking system, the MS will increase by less than the full DM. For example, if the person who got the loan for $800 spent only $700 and kept $100 in cash for emergency, only $700 would go the next stage instead of $800, that would reduce the DM, DM < 5.

2. Excess reserves - if banks hold some excess reserves, the DM will also be less than 5. Banks only hold about 1% excess reserves.

Currency leakages and excess reserves will result in a DM that is less than its full potential. But since banks hold very few excess reserves, and since people hold very little cash, the actual DM would usually be very close to the full DM. Example: with credit cards, checks, ATMs, there is little need to hold very much cash.


Most countries have a central banking authority that controls the MS and conducts monetary policy. In US it is the FRS, in UK it is the Bank of England, in Europe, the European Central Bank. Central banks are supposed to promote monetary stability. To achieve that goal, most effective central banks are supposed to be independent of the political authorities - pres/prime minister, Congress/Parliament, etc.

In most cases, the lower the inflation, the more independent the central bank. The higher the inflation the less independent the central bank. Example - Turkey, Brazil, most S. American countries.

Structure of the Fed -

FRS is a quasi-governmental agency, part private, part public, supposed to be independent from Congress/Pres.

12 FRS districts - 25 regional branches. We are in the Chicago district, and there is a regional FRS branch in Detroit. See page 332.

Board of Governors - Decision-making center of the FRS. 7 Members appointed to 14 year staggered terms by Pres and approved by Congress. Every other year a term expires, so the most number of appointees by any one president is 2 per term, or 4 total. President designates one of the members as Chair for a four year term. Greenspan is in fourth term as chairman of FRS. Appointed by Reagan in 1987, been through four presidents. Current term expires June 2004.

Board of Governors has two major functions:

1. Regulate the banking industry, e.g. set reserve requirements. Lend money to banks. Provide check-clearing services.

2. Conduct monetary policy. Regulate the money supply and thereby influence inflation, interest rates and ex-rates. Promote monetary stability.

How policy is determined:

FOMC - Federal Open Market Committee - 7 Governors + president of the NY District Bank + 4 of the remaining 11 district bank presidents, who rotate on the committee. FOMC determines the Fed's policy with respect to setting money supply and interest rates. All presidents can attend meetings, but only those on the FOMC can usually vote. FOMC is the true policymaking group for establishing monetary policy.

12 District Banks operate under the control of the Board of Governors and differ from commercial banks in several important respects:

1. FRS banks are not profit-making banks. All earnings go the Dept of Treasury.

2. FRS banks can issue money, private/commercial banks cannot.

3. FRS banks are the bankers' banks. Only commercial banks can have accounts with the FRS. The FRS does 85% of check-clearing, which is facilitated by having all banks having accounts with the FRS. As the check clears, the FRS credits one bank's reserve account and debits the other banks account.

FRS goal is to promote monetary stability, full employment and econ growth. Although it is technically independent, a quasi-governmental agency, it works closely with Congress, the Treasury, and the President's Council of Econ Advisors, to co-ordinate fiscal/monetary policy. Fed reports to Congress twice a year at public hearings.

INDEPENDENCE OF THE CENTRAL BANK - Important issue. The Central Bank should be independent from the influence of politicians, so that they can set monetary policy for the best long-term interest of the economy. Politicians are usually more short-sighted, and want to get re-elected. The central bank can control inflation more effectively when they are not accountable to the fiscal policymakers, elected officials, President, Congress, etc.


The Fed has three tools of monetary policy:

1. Set reserve requirements

2. Open market operations - buying/selling Treasury securities

3. Setting the discount rate - the rate it will lend money to member banks.


Reserves are: a) vault cash and b) bank deposits at the Fed. Both can be used to meet depositors' withdrawals. Fed establishes minimum reserve requirements to make sure that all banks can meet a sudden increase in cash withdrawals. Stabilizes the banking system.

Currently banks are not required to have reserves against time deposits/savings accounts, only transaction accounts - checking accounts (int) and demand deposits (no int). Reserve ratios are listed on page 304. 3% up to $41.3m and then 10%.

Fed can affect the MS by changing the reserve requirements. If the Fed lowers reserve requirement, the MS will increase. If the reserve requirements were lowered from 10% to 5%, the banks would then have excess reserves. Banks don't like excess reserves, because they are non-interest bearing assets. The excess reserves would be loaned out, and the MS would increase.

Lower reserve requirements results in Expansionary monetary policy, or an easing of monetary policy.

Higher reserve requirements result in Contractionary policy, or restrictive policy or tightening. Changes in reserve requirements are rarely used as a tool of monetary policy. Reserve requirements are usually put in place and left alone.


Used MOST often.

Unlike us, or businesses or even other govt. agencies, state govt., the FRS can write a check without funds in its account. When the Fed buy things, it creates money. The Fed is restricted to buying/selling treasury securities, but the process would work no matter what it bought.

Fed buys T-bills - MS increases. Fed buys a T-bill from a bank, business or individual and writes a check with "new money." When the check is deposited, the reserves of the banking system are increased. The increased reserves support the creation of new loans, which increases the MS.

Example: Fed buys a $10,000 T-bond from me. I give the Fed a $10,000 T-bond, it writes me a check for $10,000. I deposit the check in my bank account and the bank's reserve account with the Fed is increased by $10,000. Assuming a 10% reserve requirement, the bank can create $9000 in new loans. That $9000 gets spent and when deposited, increases the reserves of another bank by $9000. Only $900 has to be kept as a deposit, so $8100 gets loaned out, etc.... The deposit expansion takes place over many banks and many transactions.

The Fed directly controls the Monetary Base, which is bank reserves (vault cash + deposits at Fed) plus the currency in circulation. The monetary base in 2001 was approx $635B and M1 was approx $1203B. There was about $594B in cash and $41B in bank reserves. Actual money multiplier ($1203/635) was about 1.89x.

Remember that the Deposit Multiplier (DM) is 1 / (required reserve ratio). If the required reserve ratio is .10, the DM would be 10. It is actually less than that because of leakages:

1. People hold cash, outside of the banking system, reduces the effect of the full DM. The more cash people hold, the lower the actual DM.

2. Some banks hold excess reserves.

Fed can directly control the monetary base, but it cannot really directly control M1 because it can't directly control people's demand for cash, and it can't control bank's desire to hold excess reserves. The actual money multiplier (m) is around 2x.

A Money Multiplier (m) of 2 means that for every $1 increase in the Monetary Base (M0), M1 will increase by $2. If the Fed wants to increase the MS by $20B, it would engage in a $10B open market operation, it would buy $10B of treasury securities.

If the Fed wants to contract the MS, it would sell treasury securities from its portfolio. They give you a T-bill, you give them a check. When the check clears, the reserves in the banking system are reduced/contracted, which then contracts the MS. The multiplier works the same way in reverse.


If banks have a shortage of reserves, and it needs to meet the reserve requirements, it has two sources for funds: a) the Federal Reserve Bank and b) the Federal Funds market. Banks can borrow from the Fed at the Discount Rate, currently at ____. Banks can also deal directly with each other in the Fed Funds Market. Banks with excess reserves can lend money to banks that need reserves, sometimes on just an overnight basis.

The current FFR is approx _____. Most banks would rather borrow at the FFR, even if it is higher.

If the Fed lowers the discount rate, it would be easier/cheaper to borrow reserves, would be considered expansionary. If the discount rate is very low, and it is cheap to borrow, banks will not need to hold excess reserves, they will make loans.

If the Fed raises the discount rate, it is expensive to borrow and banks will hold excess reserves to avoid having to borrow at the high discount rate.


See page 308. To increase MS, or have expansionary policy or "easing of money" the FRS can:

1. Lower reserve requirements
2. Lower the discount rate
3. Open market operation (OMO) - buy T-bills

To decrease MS, or have contractionary policy or "tightening of money" the FRS:

1. Raise reserve requirements
2. Raise discount rate
3. OMO - Sell Tbills.

On net, the MS is increasing. Reserve requirements don't change very often, and the discount rate doesn't change very often. The primary tool used most often by FRS is the Open Market Operation.

See Exhibit 7, page 306. Illustrates the MS process. FRS directly affects the Monetary Base by increasing the amount of bank reserves. If the increased reserves stay in the banking system and get loaned out there is an expansionary effect, 1/res. req. If some of the new reserves are held as cash, it is a "leakage" and the multiplier effect is only 1. Reserves are "high powered" money if they stay in the banking system and are expanded.

Point: FRS can directly control the MB, but it cannot directly control M1. M1 is influenced by peoples demand for currency/cash, and by bank's willingness to hold excess reserves.

Also, since OMOs are the primary tool used to influence M1, we would expect a direct relation between growth in the MB and M1, since the FRS is expanding the MB with OMOs to increase M1.


There is a tendency to confuse the Fed and the Treasury. They are totally different and distinct. The Treasury is concerned with the federal budget and financing G exp, and is the agency that issues Treasury bills, bonds and notes to finance deficits. Treasury securities are sold at auctions to the public, not to the Fed, and this action does NOT change the MS. Just transfers money from the private sector to the public sector.

The Fed buys T-Bond in the secondary market, from individuals, banks, ins cos., etc. The Fed does NOT issue govt. securities, it just buys and sells them. Fed's action DOES change the MS.

See Thumbnail Sketch, page 310.

NEW Currency: EURO (�), introduced in 2002 in 12 European countries (Germany, Italy, France, Greece, Spain, Netherlands, etc.) to replace the marks, francs, guilders, etc. Advantages? Disadvantages?

FUTURE? 3 currencies in the world? Euro, Yen and Dollar?

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