Intro to Finance:

Part I -Money & Banking

Part II - Monetary Policy

Mr. Miller
MHS
AP Econ Macro Unit IV
 Part I
Money, banking and financial markets
Definition of financial assets
Measure of Money supply
Banks and creation of money
Money Demand
Money market
 The Banking System
Threeimportant features of the fractional
reserve banking system:
Bank profitability
Banks influence on the money supply
Exposure to bank runs
 The Nature of Money
Barter versus Monetary Exchange
A barter system (with no money) would be
awkward and extremely inefficient.
Money greases the wheels of exchange and,
thus, makes the whole economy run more
efficiently.
 The Nature of Money
The Conceptual Definition of Money
The functions of money:
1. Medium of exchange
2. Unit of account
3. Store of value

Money = an item that serves as the medium

of exchange
 The Nature of Money
What Serves as Money?
Societies have gradually moved from the use
of commodity monies to the use of fiat money
that has no commodity backing at all.
 How the Quantity of Money is
Measured
There is no single, obvious place to draw
the line between money and near
money.
M1 = coins and paper money in
circulation, plus checkable deposits
M2 = M1 + money market deposit
accounts, money market mutual funds,
and savings accounts
 MONEY SUPPLY
Definition
Currency
Token Money
Federal Reserve Notes
Little Intrinsic Value
Checkable Deposits
Commercial Banks
Thrift Institutions
 MONEY SUPPLY
= Plus...
Savings Deposits
Money Market Deposit
Accounts (MMDAs)
Smaller Time Deposits
Money Market Mutual Funds
(MMMFs)
 MONEY SUPPLY
= Plus...
Large Time Deposits

Illustrated
 MONEY SUPPLY
M1 M2 M3
Currency (coins & paper money)
plus Checkable deposits
equals M1

$1236

2003 Data
(billions of dollars)
 MONEY SUPPLY
M1 M2 M3
Currency (coins & paper money)
plus Checkable deposits
equals M1
plus Savings deposits, $1236
including MMDAs
plus Small time deposits
plus Money market mutual
fund
(MMMF) balances
equals M2 $5899
2003 Data
(billions of dollars)
 MONEY SUPPLY
M1 M2 M3
Currency (coins & paper money)
plus Checkable deposits
equals M1
plus Savings deposits, $1236
including MMDAs
plus Small time deposits
plus Money market mutual
fund
(MMMF) balances
equals M2 $5899

plus Large time deposits 2003 Data

(billions of dollars) $8595
equals M3
 Two Definitions of the Money
Supply, January 2005

Currency Checking deposits

Outside banks In commercial
$710 billion Banks $330 billion M1
$1361 billion

Savings
Other deposits
checkable $4378 billion
deposits
$321 billions

M1 = $1361 billion Money market

mutual funds
$704 billion
M2 = $6443 billion
WHAT ABOUT CREDIT CARDS?
 WHAT ABOUT CREDIT CARDS?

NOT
MONEY!

LOANS!
 WHAT BACKS THE MONEY
SUPPLY?

Q: So, What Backs the Money Supply?

A: The governments ability to maintain

its Stable Value!
 How Banks and
Thrifts Create Money
 The Banking System
Bank Regulation
Deposit insurance (FDIC)
Eliminates the motive for customers to withdraw
funds because of bad news regarding the banks
finances
Moral hazard
When an individual is insured against risk, he/she
puts forth little effort to avoid risk
 The Banking System
Bank Regulation
Bank Supervision
Needed to reduce moral hazard problem
Ensures banks take only sensible, defensible risks
Controls the money supply
Reserve Requirements
Helps control the money supply
 The Origins of the Money
Supply
How Bankers Keep Books
Banks keep balance sheets
Assets = liabilities + net worth
Assets include:
Reserves
Loans
Liabilities include:
Deposits owed to customers.
 Banks and Money Creation
The
Limits to Money Creation by a Single
Bank
Banks can lend money in their vault that is
above the minimum required reserves.
In doing so, they create new money.
 Banks and Money Creation
Multiple Money Creation by a Series of
Banks
When all banks make loans with funds they
have that are above the required reserves,
the economys money supply expands.
 BALANCE SHEET OF A
COMMERCIAL BANK
ASSETS = LIABILITIES + NET WORTH

Fractional Reserve Banking System

Money Creation & Reserves
Bank Panics & Regulation
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

TRANSACTION
1

Creating a bank
$250,000 Cash
for
Stock Shares
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $250,000 Stock Shares $250,000

Deposit Added to Vault Cash

 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $250,000 Stock Shares $250,000

TRANSACTION
2

Acquiring
Property and
Equipment
$240,000 Cash
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $ 10,000 Stock Shares $250,000

Property 240,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $ 10,000 Stock Shares $250,000

Property 240,000
TRANSACTION
3

Accepting
Deposits
$100,000 Cash
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $110,000 Checkable

Property 240,000 Deposits $100,000
Stock Shares 250,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash NOTES:
$110,000 Checkable
Property 240,000 Deposits $100,000
Bank deposits
Stockare
Shares 250,000
subject to a reserve
requirement.
Commercial banks
required reserves
Reserve
ratio = Commercial banks
checkable-deposit
liabilities
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $110,000 Checkable

Property 240,000 Deposits $100,000
Stock Shares 250,000
Three Important Issues...
1 - Excess Reserves = Actual
Reserves - Required Reserves
(assume 20% reserve requirement)
$110,000 - 20,000 = $90,000
2 Control of Lending Ability
3 - Asset or Liability to Which Bank?
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $110,000 Checkable

Property 240,000 Deposits $100,000
TRANSACTION Stock Shares 250,000
4

Deposits
at the FED
$110,000 Cash
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $ 0 Checkable
Reserves 110,000 Deposits $100,000
Property 240,000 Stock Shares 250,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $ 0 Checkable
Reserves 110,000 Deposits $100,000
TRANSACTION
Property 240,000 Stock Shares 250,000
5

A check is
drawn against
the bank
$50,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash $ 0 Checkable
Reserves 60,000 Deposits $ 50,000
Property 240,000 Stock Shares 250,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Cash NOTES:
$ 0 Checkable
Reserves 60,000 Deposits $ 50,000
Property Banks240,000
create money
Stock Shares 250,000
by lending excess
reserves and destroy
it by loan repayment.
Purchasing bonds
from the public also
creates money.
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Reserves $ 60,000 Checkable

Property 240,000 Deposits $ 50,000
TRANSACTION Stock Shares 250,000
6

Make a loan
from excess
reserves
$50,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Reserves $ 60,000 Checkable

Loans 50,000 Deposits $100,000
Property 240,000 Stock Shares 250,000

Making the loan

created money!
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Reserves $ 10,000 Checkable

Loans 50,000 Deposits $ 50,000
Property 240,000 Stock Shares 250,000

After a check for the $50,000

is drawn against the bank
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Reserves $ 10,000 Checkable

Loans 50,000 Deposits $ 50,000
TRANSACTION
Property 240,000 Stock Shares 250,000
7

Repaying a
loan with cash
$50,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Reserves $ 10,000 Checkable

Loans 0 Deposits $ 0
Property 240,000 Stock Shares 250,000

$50,000 in money supply

is destroyed!
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Reserves $ 60,000 Checkable

Securities 50,000 Deposits $100,000
TRANSACTION
Property 240,000 Stock Shares 250,000
8

(Assume previous
balance sheet)
Buy Government
Securities
$50,000
 FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
ASSETS NET WORTH

Reserves $ 60,000 Checkable

Securities 50,000 Deposits $100,000
Property 240,000 Stock Shares 250,000

Bankers pursue two conflicting goals:

Profits and Liquidity
Use of Federal Funds Market
Federal Funds Rate
MULTIPLE DEPOSIT EXPANSION PROCESS
Amount bank
Acquired reserves Required Excess can lend - New
Bank and deposits reserves reserves money created

A $100.00 $20.00 $80.00 $80.00

B 80.00 16.00 64.00 64.00
C 64.00 12.80 51.20 51.20
D 51.20 10.24 40.96 40.96
E 40.96 8.19 32.77 32.77
F 32.77 6.55 26.21 26.21
G 26.21 5.24 20.97 20.97
H 20.97 4.20 16.78 16.78
I 16.78 3.36 13.42 13.42
J 13.42 2.68 10.74 10.74
K 10.74 2.15 8.59 8.59
L 8.59 1.72 6.87 6.87
M 6.87 1.37 5.50 5.50
N 5.50 1.10 4.40 4.40
Other banks 21.99 4.40 17.59 17.59
Total amount of money created by the banking system $400.00
MULTIPLE DEPOSIT EXPANSION PROCESS
Amount bank
Acquired reserves Required Excess can lend - New
Bank and deposits reserves reserves money created

A $100.00 $20.00 $80.00 $80.00

B 80.00 16.00 64.00 64.00
C 64.00 12.80 51.20 51.20
D
E
Money
51.20
40.96
10.24
8.19
40.96
32.77
40.96
32.77
F
G
destruction works
32.77
26.21
6.55
5.24
26.21
20.97
26.21
20.97
H
I
in exactly the same
20.97
16.78
4.20
3.36
16.78
13.42
16.78
13.42
J
K
multiple way!
13.42
10.74
2.68
2.15
10.74
8.59
10.74
8.59
L 8.59 1.72 6.87 6.87
M 6.87 1.37 5.50 5.50
N 5.50 1.10 4.40 4.40
Other banks 21.99 4.40 17.59 17.59
Total amount of money created by the banking system $400.00
THE MONETARY MULTIPLIER

Monetary 1
Multiplier = Required reserve ratio

Maximum
checkable-
deposit = Excess
reserves x Monetary
Multiplier
creation
OUTCOME OF MONEY EXPANSION
$100
New reserves $20
$80 Required
Excess reserves
reserves

$400 $100
Initial
Bank system lending Deposit

Money Created
OUTCOME OF MONEY EXPANSION
$100
New reserves $20
$80 Required

Leakages exist...
Excess reserves
reserves

Currency Drains
Excess Reserves $100
$400
Initial
Bank system lending Deposit

Money Created
 Banks and Money Creation
TheProcess in Reverse: Multiple
Contractions of the Money Supply
Deposits, and with them the money supply,
contract when reserves are reduced.
Banks reduce their loan commitments.
Calculation of the contraction in the money supply
utilizes the same formula as for money expansion.
 Why the Deposit Creation
Formula Is Oversimplified

Individuals hold some portion of additions

to their money in the form of cash.
Banks sometimes hold reserves above the
required minimum.
The Money Market
THE DEMAND FOR MONEY
Transactions Demand, Dt
varies directly with nominal
GDP
Asset Demand, Da
varies inversely with the
interest rate
Liquidity Preference
illustrated...
 THE DEMAND FOR MONEY

Rate of interest, i (percent)

Transactions
Demand, Dt +
10

7.5

2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
 THE DEMAND FOR MONEY

Rate of interest, i (percent)

Transactions
Demand, Dt + Asset
Demand, Da =

Rate of interest, i (percent)

10 10

7.5 7.5

5 5

2.5 2.5
Dt Da
0 0
0 50 100 150 200 250 300 0 50 100 150 200 250 300
Amount of money Amount of money
demanded (billions demanded (billions
of dollars) of dollars)
 THE DEMAND FOR MONEY

Rate of interest, i (percent)

Transactions
Demand, Dt + Asset
Demand, Da = Total demand
for money, Dm

Rate of interest, i (percent)

Rate of interest, i (percent)

10 10 10

7.5 7.5 7.5

5 5 5

2.5 2.5 2.5

Dm
Dt Da
0 0 0
0 50 100 150 200 250 300 0 50 100 150 200 250 300 0 50 100 150 200 250 300
Amount of money Amount of money Amount of money
demanded (billions demanded (billions demanded (billions
of dollars) of dollars) of dollars)
 THE DEMAND FOR MONEY
Transactions
Demand, Dt + Asset
Demand, Da = Total demand
for money, Dm
ADD THE
Sm
Rate of interest, i (percent)

Rate of interest, i (percent)

Rate of interest, i (percent)

10
MONEY SUPPLY 10 10

7.5 7.5 7.5

TO FIND THE
5
EQUILIBRIUM RATE 5 5 ie
2.5
D
OF INTEREST
D
2.5 2.5
Dm
t a
0 0 0
0 50 100 150 200 250 300 0 50 100 150 200 250 300 0 50 100 150 200 250 300
Amount of money Amount of money Amount of money
demanded (billions demanded (billions demanded (billions
of dollars) of dollars) of dollars)

Equilibrium
Interest Rate
THE MONEY MARKET
Sm

Rate of interest, i (percent)

10 Suppose the money
supply is decreased
7.5 from $200 billion, Sm,
to $150 billion Sm1.
5 ie

2.5 Dm

0
0 50 100 150 200 250 300
Amount of money demanded
(billions of dollars)
THE MONEY MARKET
Sm1 Sm

Rate of interest, i (percent)

10
A temporary shortage
of money will require
7.5 the sale of some assets
to meet the need.
5 ie

2.5 Dm

0
0 50 100 150 200 250 300
Amount of money demanded
(billions of dollars)
THE MONEY MARKET
Sm

Rate of interest, i (percent)

10 Suppose the money
supply is increased
7.5 from $200 billion, Sm,
to $250 billion Sm2.
5 ie

2.5 Dm

0
0 50 100 150 200 250 300
Amount of money demanded
(billions of dollars)
THE MONEY MARKET
Sm Sm2

Rate of interest, i (percent)

10 A temporary surplus
of money will require
7.5 the purchase of some
assets to meet the de-
5 ie sired level of liquidity.

2.5 Dm

0
0 50 100 150 200 250 300
Amount of money demanded
(billions of dollars)
THE MONEY MARKET
Sm Sm2

Rate of interest, i (percent)

10 A temporary surplus
of money will require
7.5
Bonds are assumed the purchase of some
as a typical asset assets
with to meet the de-
ie sired level of liquidity.
5 lower prices associated
with higher
2.5 interest rates Dm

0
0 50 100 150 200 250 300
Amount of money demanded
(billions of dollars)
 Part II
Monetary Policy
Central bank and control of the money
supply
Tools of central bank policy
Quantity theory of money
Real versus nominal interest rates
 Monetary Policy
Federal Reserve System:
Independent government agency created in 1913
Controls how much money is in circulation
12 Regional Federal Reserve Banks and 13,000 Private
Member Banks
Fed Chairman oversees Board of Governors that supervise
the Feds Banking services and policies
Monetary Policy is Fast
instantaneous impact on markets and banking / financial
system
Not burdened by the political process or government
bureaucracy of fiscal policy
THE FEDERAL RESERVE AND
THE BANKING SYSTEM
Federal
Open Market Board of
Committee Governors

12 Federal
Reserve Banks

Thrift Institutions
Commercial (Savings & loan associations,
mutual savings banks, credit
Banks unions)

The Public
(Households and
businesses)
GOALS OF MONETARY POLICY

to assist the
economy in achieving
a full-employment,
noninflationary level
of total output
 Monetary Policy Tools
Reserve Requirements:
Determines the minimum $ that banks must have at
all time
Discount rate:
interest rate the fed charges to member banks
Lower rate more likely to borrow from FED = more
money in the economy = more loans
Higher rate = less money in the economy loans more
difficult to obtain
Open-market operations:
Purchase or sale of bonds to finance government
Bonds: certificates issued by the government to a
lender from whom it has borrowed money
Increase and decrease money in the economy by
buying bonds decreases money by selling bonds
 The Rates
Fed Funds:
Bank to bank overnight loans
Discount:
Fed to banks
Prime:
Banks to you (if you have good credit)
Fed funds + 3%
What you pay to borrow
CONSOLIDATED BALANCE SHEET OF
THE FEDERAL RESERVE BANKS
ASSETS
Securities
Loans to Commercial Banks

LIABILITIES
Reserves of Commercial
Banks
Treasury Deposits
Federal Reserve Notes
TOOLS OF MONETARY POLICY
Open-Market Operations
Buying Securities
From commercial banks...
Bank gives up securities
FED pays bank
Banks have increased reserves
From the public...
Public gives up securities
Public deposits check in bank
Banks have increased reserves
TOOLS OF MONETARY POLICY
Open-Market Operations
Selling Securities
To commercial banks...
FED gives up securities
Bank pays for securities
Banks have decreased reserves
To the public...
FED gives up securities
Public pays by check from bank
Banks have decreased reserves
 FEDERAL RESERVE
PURCHASE OF BONDS
New reserves $200
Purchase of a $800 Required
$1000 bond Excess
Reserves reserves
from the public...

$1000
$4000 Initial
Bank System Lending Deposit

Total Increase in Money Supply ($5000)

Effects of an Open-Market
Purchase of Securities
TOOLS OF MONETARY POLICY
Open-Market Operations
The Reserve Ratio
Raising the Reserve Ratio
Banks must hold more reserves
Banks decrease lending
Money supply decreases
Lowering the Reserve Ratio
Banks may hold less reserves
Banks increase lending
Money supply increases
TOOLS OF MONETARY POLICY
Open-Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
Buy Securities
Decrease Reserve Ratio
Lower Discount Rate
TOOLS OF MONETARY POLICY
Open-Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
Tight Money Policy
Sell Securities
Increase Reserve Ratio
Raise Discount Rate
Balance Sheet Changes,
Borrowing from Fed
TOOLS OF MONETARY POLICY
Open-Market Operations
The Reserve Ratio
The Discount Rate
Discuss relative
Easy Money Policy
importance
Tight Money Policy
of each
Sell control
Securities
Increase Reserve Ratio
Raise Discount Rate
 How Monetary Policy Works
Investment and Interest Rates
interest rates investment spending
investment multiplier effect
Lowers GDP
interest rates opposite
 How Monetary Policy Works
Monetary Policy and Total Expenditure
Fed actions
money supply
interest rates
interest rate investment
investment AD
AD GDP
MONETARY POLICY AND EQUILIBRIUM GDP
Sm1 Sm2 Sm3
Investment

Nom rate of interest, i

10 10 Demand

8 8

6 6
Dm
0 0
Quantity of money demanded and supplied Amount of investment, i

AS If the Money Supply

Increases to Stimulate
the Economy
Interest Rate Decreases
Price level

P3
Investment Increases
P2 AD & GDP Increases
P1 AD3(I=$25) with slight inflation
AD2(I=$20) Increasing money supply
AD1(I=$15) continues the growth
Real domestic output, GDP but, watch Price Level.
 Tight Monetary Policy And Equilibrium GDP
Sm3 Sm2 Sm1
Nom rate of interest, i Investment
10 10 Demand

8 8

6 6
Dm
0 0
Quantity of money demanded and supplied Amount of investment, i

AS If the Money Supply

Decreases to cool
the Economy
Interest Rate Increases
Price level

PL1
Investment Decreases
PL2 AD & GDP Decreases
PL3 AD1(I=$25) with lower PL
AD2(I=$20) Decreasing money supply
AD3(I=$15) continues the cooling
Real domestic output, GDP as Price Level falls.
 Money and the Price Level in
the Keynesian Model
Expansionary monetary policy causes
some inflation under normal
circumstances.

How much inflation it causes depends on

the state of the economy.
Represented by the slope of the AS curve
The Inflationary Effects of
Expansionary Policy
D0 D1

$500 billion S

B
Price Level

103

E
100

S
D0 D1

6,000 6,400
Real GDP
MONETARY POLICY IN ACTION
Strengths of monetary policy
Speed and flexibility
Isolation from political
pressure
Focus on the Federal Funds Rate
The Federal Funds Rate
The Prime Interest Rate
Recent Monetary Policy
Problems and Complications
Lags
Cyclical Asymmetry
Liquidity Trap
Monetary
Policy
Impact
on Xn
(Net
Export
Effect)
Net Export Effect (Monetary)

Easy monetary policy

interest rates / $ depreciation

demand for U.S. exports

Xn can AD
Net Export Effect (Monetary)

Tight monetary policy

interest rates / $ appreciation

demand for U.S. exports

Xn can AD
 NOTE: KNOW FOR AP EXAM
FISCALXn EFFECT IS THE OPPOSITE
OF THE MONETARY Xn EFFECT!
 Can You Discuss These?
Money Multiplier
Fed Funds Rate
Prime Rate
Discount Rate
Open Market Operations
Reserve Requirement
Easy Money
Tight Money
Monetarism
RATIONALE FOR A MONETARY RULE
Federal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP
ASLR1 ASLR2
Fed Increases
Price Level The Money
Supply
P1 Resulting in
P2
AD1
Q1 Q 2
Real Domestic Output, GDP
RATIONALE FOR A MONETARY RULE
Federal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP
ASLR1 ASLR2
Growth
Price Level Without
Inflation or
P1 Deflation
P2 AD2
AD1
Q1 Q 2
Real Domestic Output, GDP
 Velocity and the Quantity
Theory of Money

Velocity= number of times per year that

an average dollar is spent on goods and
services

V = Nominal GDP Money stock

 Equation of Exchange
M V = P Q = Nominal GDP
 Velocity and the Quantity
Theory of Money
The equation of exchange is simply an
accounting identity.
If V were constant, the equation would
become a strict quantity theory of money.
M Nominal GDP
Implies that Fed can control nominal GDP
CAUSES OF MACRO INSTABILITY
Mainstream View
Changes in Investment
Ca + Ig + Xn + G = GDP
Adverse Aggregate Supply
Shocks
Monetarist View
Equation of Exchange
M V = P Q = Nominal GDP
Stable Velocity
CAUSES OF MACRO INSTABILITY
Summary
Mainstream View
Instability of Investment is the
Main Cause of Output Changes
Monetary Policy is a
Stabilizing Factor
Monetarist View
With a Stable Velocity,
Nominal GDP Depends Upon
the Money Supply
 Velocity and the Quantity
Theory of Money

Inthe United States, however, velocity is

not constant.
 Velocity and the Quantity
Theory of Money

The Determinants of Velocity

Efficiency of the payments system
Interest rates
 Velocity and the Quantity
Theory of Money

The Determinants of Velocity

Since these factors change over time, velocity
also changes.
Only by studying the determinants of V can
we hope to predict the growth rate of nominal
GDP from knowledge of the growth rate of M.