monetary system.docx

monetary system.docx

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monetarysystem

monetarysystem

THEMONETARYSYSTEMIntroduction:

NowthatwehavecompletedourstudyofthedeterminantsofrealpercapitalGDPgrowthinthelongrun,weturntoprices/inflationinthelongrun.Forthisstudy,weneedtointroduceanewplayerintothesystemTheFederalReserve（orTheFed）.ThissetofnotesdetailstheFedanddiscussestheirorganizationandpurpose.ThenextsetofnoteswilllinkuptheFedsactionstopricesinthelongrun.Question:

Whywouldyougiveupsomethingofgreatvalue（acar,food,pennstateseasontickets,ect..）inexchangeforapieceofpaperthatis,onitsown,essentiallyuseless?

Answer:

Becauseyouareconfidentthattheywillbeabletogivethemoneytosomeoneelseinthefutureforsomethingyoudesiremorethanwhatyougaveup.Thereasontheywouldacceptitisthatanotherpartywouldacceptthemoney,andsoon.Thatis,thisgreenpaperisvaluablebecauseitisanacceptedmeansofpayment.Supposewehadnomoney,whatwouldwedo?

Barter:

theexchangeofonegoodorserviceforanother.Example,yougotoarestaurantforamealandinexchangeyoudosomethingthattheyarevalueenough（suchaswashingdishes）.Problem:

Abartersocietyhastroubleallocatingsocietysscarceresourcesbecausesuchacaserequiresadoublecoincidenceofwantstheunlikelyoccurrencethattwopeopleeachhaveagoodorservicethattheotherwants.Further,moneymakestrademucheasier:

ARestaraunteurdoesnotcarethatyoucoulddosomethingvaluableforhimheisperfectlyhappytoacceptyourmoney,becauseheknowsthatotherswillinturnacceptitfromhim.Itallowstradetoberoundabout.Asmoneyflowstradeisfacilitated,allowingeachpersontospecializeinwhatheorshedoesbestandtherebyraisingeveryonesstandardofliving.Keys:

1.moneyallowsustospecializeratherthanproducemuchofwhatweneed2.Moneyencouragestradeandmakesitmucheasiertodoso.Amonetarysystemsignificantlyraisesacountrysstandardofliving.Agenda:

1.Whatismoney?

2.Howthebankingsystemcreatesmoney?

3.Howthegovernmentcontrolsthequantityofmoneyincirculation.4.Restoftimeisdevotedtowardslinkingmoneytootherkeymacroeconomicvariables（inflationbeingtops.）.Rememberthatwearestillinthelong-run!

TheMeaningofMoney:

Whatismoney?

MoneyisNOTwealthBillgateshasmuchmorewealththanhedoesmoney.Sohowdowedefinemoney?

ByitsfunctionsFunctionsofmoney:

1.Amediumofexchange:

anitemthatbuyersgivetosellerswhentheywanttopurchasegoodsandservices.Moneyisanacceptedmediumofexchange.2.Aunitofaccount:

theyardstickpeopleusetopostpricesandrecorddebts（makescomparisonsofrelativeworthofdifferentgoodsMUCHeasiercontrastwithbarter!

3.Astoreofvalue:

anitemthatpeoplecanusetotransferpurchasingpowerfromthepresenttothefuture.Notethanmanythingsactasastoreofvalue.Wealthisthesumofallitemsthatserveasastoreofvalue.Keypoint:

Liquidity:

theeasewithwhichanassetcanbeconvertedintotheeconomysmediumofexchange.Moneyisthemostliquid（bydefinition）.Somestocksandbondsarefairlyliquid.ARenoirpaintingismuchlessliquid（wineisaliquid,butitisnotaveryliquidasset!

）.Hinttothefuture:

Althoughmoneyisthemostliquidwaytoholdyourwealth,itsvaluedropswhenpricesrise（unlikeotherassets）.Thisnotionwillbeveryimportantinlinkingmoneytoinflation.Rememberabuildingblock:

Inflationhappenswhenthegovernmentprintstoomuchmoney.Thekindsofmoney:

Commoditymoney:

moneythattakestheformofacommoditywithintrinsicvalue.Examples:

gold,cigarettes（POWcamps,jail,theSovietUnioninthelate1980s）.Fiatmoney:

moneywithoutanyintrinsicvaluethatisusedasmoneybecauseofgovernmentdecree.Thisnoteislegaltenderforalldebts,publicandprivate.Thekeyforfiatmoneytobeviableisexpectationsandconfidence.MoneyintheU.S.economy:

Whatisthemoneystock-thequantityofmoneycirculatingintheeconomy?

Howwouldyoumeasurethestockofmoney?

Totalmoneyintheeconomy=?

Componentsofmoney:

1.Currency:

thepaperbillsandcoinsinthehandsofthepublic.2.Demanddeposits:

balancesinbankaccountsthatdepositorscanaccessondemandbywritingacheck.Whataboutothers?

Savingsaccounts?

Moneymarketmutualfunds?

-shouldthesealsobeconsidered?

Inotherwords,inourcomplexeconomy,whatassetsshouldbeconsideredmoneyandwhichonesdoweleaveoutinourmeasurementofthestockofmoney?

Hardtoanswer,sowehavevariousdefinitionsofthestockofmoney:

M1:

Currency,travelerschecks,demanddeposits,othercheckabledepositsM2:

M1+savingsdeposits,smalltimedeposits,moneymarketmutualfunds.Keypoint:

moneyismorethanjustcurrency:

Interestingsidebar:

whereisallthecurrency?

TotalcurrencyintheU.S.economyis$380billion.Divideby200million（numberofadults）andyougetalmost$1900!

!

!

Howmanyofyouhave$1900incurrency?

Wherediditgo?

?

?

（Illegalactivities,lost,abroad）.Nowfortheimportantstuff!

TheFederalReserve:

TheFed:

thecentralbankoftheUnitedStatesaninstitutiondesignedtooverseethebankingsystemandregulatethequantityofmoneyintheeconomy.Organizationofthefed:

FedisrunbyitsBoardofGovernors:

sevenmembersappointedbythepresidentandconfirmedbytheSenate.14yeartermsdesignedtoinsulatethemfrompoliticalpressures.ChairmanoftheBoard:

AlanGreenspan（4yeartermappointedbythepresident）.FedsystemismadeupoftheFederalreserveboardand12Federalreservebanks（oneinRichmond）.Primaryjobsofthefed:

1.regulatebanksandensurethehealthofthebankingsystem（regionalbanksjob）.Notethatthefedisalsothebankersbank2.controlthequantityofmoneythatisavailableintheeconomycalledthemoneysupplymonetarypolicy:

thesettingofthemoneysupplybypolicymakersinthecentralbank.AttheFed,monetarypolicyismadebytheFederalOpenMarketCommittee.FederalOpenmarketcommittee:

7membersoftheboardand5ofthe12regionalbankpresidents.Theymeeteverysixweeksinordertodiscusstheconditionoftheeconomyandconsiderchangesinmonetarypolicy.intuition:

imaginethefeddroppingbagsofmoneyfromhelicoptersrandomlythroughouttheU.S.（inpracticeitismuchmorecomplicated）.Punchlineinthefuture:

theyreallychangethemoneysupplythroughopen-marketoperationsthepurchaseandsaleofU.S.governmentbonds.Iftheywanttoincreasethemoneysupplytheybuygovernmentbondsfromthepublic,therebyputtingmoneyinthehandsofthepublic.Iftheywanttodecreasethemoneysupplythentheysellgovernmentbonds,therebytakingmoneyawayfromthepublic.MoreonthislaterImportanceofmonetarypolicy:

inflationinthelong-run,employmentandproductionintheshort-run.Banksandthemoneysupply:

Whatroletoregularbanksplayinthemonetarysystem?

Recall,demanddeposits（apartofmoney）isheldinbanks,sothebehaviorofbankscaninfluencethequantityofdemanddepositsintheeconomy,and,therefore,themoneysupply.Supposetherearenobanks,andcurrencyistheonlyformofmoney.Supposethatthereis$100ofcurrency,hencethemoneysupply=$100.NowsupposesomeoneopensupabankFirstnationalbank.Supposefurtherthatthebankdoesnotmakeanyloans.Reserves:

depositsthatbankshavereceivedbuthavenotloanedout.So,thusfar,wehave100%reservebanking!

Tosummarize,hereisaT-accountforfirstnationalbank:

FirstNationalBankAssetsLiabilitiesReserves$100Deposits$100.00Assets:

（reservesitholdsinitsbank）.Liabilities:

amountitowesdepositors.Note:

eachdepositinthebankreducescurrencyandraisesdemanddepositsbyexactlythesameamount,leavingthemoneysupplyunchanged.Nowletsmoveontoamorerealisticcase.Moneycreationwithfractionalreservebanking:

Fractional-reservebanking:

abankingsysteminwhichbanksholdonlyafractionofdepositsasreserves.Supposefirstnationalbankdecidestokeep10%ofitsdepositsinreserveandtoloanouttherest.Reserveratio:

thefractionofdepositsthatbanksholdasreserves.FirstNationalBankAssetsLiabilitiesReserves:

$10.00Deposits:

$100.00Loans:

$90.00Question:

Nowwhatisthemoneysupply?

Currencyplusdemanddeposits:

$90+100=$190.Byloaningoutafractionofreserves,banksincreasethemoneysupply.Anyquestions?

?

?

?

TheMoneymultiplier:

Thecreationofmoneydoesntstopwithfirstnationalbank.Supposethe$90loanwasusedtobuyabikefromsomeone,andtheydepositthe$90intotheSecondnationalbank.Thisleadsto:

SecondnationalbankAssets:

Liabilities:

Reserves:

$9Deposits:

$90Loans:

$81Afterthedeposit,thebankkeeps10percentasreserves（$9）andloansouttherest（$81）.Thus,secondnationalbankcreated$81innewmoney.Theprocessgoesonandon.Eachtimemoneyisdepositedandabankloanismade,moremoneyiscreated.Question:

Howmuchmoneyiseventuallycreatedbythatinitial$100deposit?

100+90+81+72.90+..=$1,000.Moneymultiplier:

theamountofmoneythebankingsystemgenerateswitheachdollarofreserves.Inthiscase$100ofreservesgenerates1,000ofmoney,sothemoneymultiplieris10.Question:

Whatdeterminesthesizeofthemoneymultiplier?

Answer:

moneymultiplier=1/RwhereR=reserveratio.Thehigherthereserveratio,thelessofeachdepositbanksloanout,thesmallerthemoneymultiplier.TheFedstoolsofmonetarycontrol:

TheFedscontrolofthemoneysupplyisindirect;itworksthroughthebankingsystem.Tools:

1.open-marketoperations（buyingandsellingU.S.bonds）2.reserverequirements3.discountrateOpenmarketoperations:

Openmarketoperations:

thepurchaseand