Money, Prices, & the Federal ReserveChapter 10 Learning Objectives. You should be able to:Functions of MoneyComponents of M2 and M1The Money MultiplierSlide 6Slide 7An Example of the Creation of MoneySlide 9Determining How Many Demand Deposits Will Be CreatedSlide 11Slide 12Slide 13Equation 10.2Financial PanicsAnatomy of a Financial PanicGovernment Policy to Prevent PanicSlide 18The Benefits and Problems of GuaranteesFederal Reserve SystemFederal Reserve DistrictsFederal Reserve Bank of New YorkBoard of GovernorsNew Fed ChairFederal Open Market CommitteeFed Funds RateSlide 27Most Important Tool of Monetary PolicyTwo Other Tools of Monetary PolicyQuantity EquationMoney Growth and InflationSlide 321Money, Prices, & the Federal ReserveChapter 102Chapter 10 Learning Objectives. You should be able to:•Describe the three functions of money.•List the components of M1 and M2.•Explain how banks create money.•Define a bank panic and discuss the role of the FDIC in preventing bank panics.•Describe the structure of the Fed.•List the three tools of monetary policy and explain how they operate.•Write down the quantity equation and explain its economic significance.3Functions of Money•Medium of exchange.•Unit of account.•Store of wealth.4Components of M2 and M1Components of M1Components of M2Savings deposits (48%)Checking accounts (49%)Small-denomination time deposits (15%)Currency (50%)M1 (28%)Money market mutual funds (16%)Traveler’s checks (1%)M1 (21%)McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.5The Money Multiplier•Banks lend a portion of their deposits keeping the balance as reserves.•Reserves are vault cash and the bank’s deposits at the Fed.6•The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals.7•The required reserve ratio is the percentage of their deposits banks are required to hold by the Fed.•If banks choose to hold an additional amount, this is called the excess reserve ratio.8An Example of the Creation of Money•The first 7 rounds of the money creation process is illustrated on the following table.•Assume a deposit of $10,000 and a reserve ratio of 20 percent.•Assume that all new money remains in the banking system, none is held as currency.9An Example of the Creation of Money10Determining How Many Demand Deposits Will Be Created•To find the total amount of deposits that will eventually be created, multiply the original deposited amount by 1/r, where r is the reserve ratio.111213Determining How Many Demand Deposits Will Be Created•If the original deposit is $100 and the reserve ratio is 10 percent, then:Money multiplier = 1/.10 =10Multiply original deposit by the multiplier:10 X $100 = $1,00014Equation 10.2Money Supply =Currency held by public + Bank Reserves/Desired reserve-deposit ratio15Financial Panics•The financial history of the world is filled with stories of financial upheavals and monetary problems.•In the 1800s, local banks in the U.S. were allowed to issue their own notes, which often became worthless.16Anatomy of a Financial Panic•Financial systems are based on trust that expectations will be fulfilled.•Banks borrow short and lend long.•If people lose faith in banks, the banks cannot keep their promises.17Government Policy to Prevent Panic•To prevent panics, the U.S. government has guaranteed the obligations of various financial institutions.•The most important guaranteeing program is the Federal Deposit Insurance Corporation (FDIC).18Government Policy to Prevent Panic•Financial institutions pay a small premium for each dollar of deposit to the FDIC.•The FDIC puts the money into a fund used to bail out banks experiencing a run on deposits.19The Benefits and Problems of Guarantees•A lack of deposit guarantees act as an effective restraint or discipline on bank lending policies.•When deposits are guaranteed, some banks may make risky loans knowing that the depositors will not leave.•Moral hazard problem.20Federal Reserve System•Passed through Congress narrowly in December 1913•Regional banks to disperse power and allay fears of monopoly capitalism•Lender of last resort (discount loans only)•12 - 7- 1221Federal Reserve Districts22Federal Reserve Bank of New York23Board of Governors•7 members.•14 year non-renewable terms, one opens up every second January.•Chairman has 4 year renewable term.24New Fed ChairBen BernankeAppointed by President Bush on October 24, 2005.Takes office February 1, 2006.25Federal Open Market Committee12 members7 members of Board of Governors + 5 Federal Reserve Bank Presidents (always including the President of the FRBNY)Meets every 6-8 weeks in Washington to determine course of monetary policy26Fed Funds Rate•Rate of interest that banks charge one another for short-term loans.•Determined by supply of and demand for reserves•Fed adjusts the supply of reserves through open market operations.2728Most Important Tool of Monetary PolicyOpen market operations: the purchase or sale of Treasury securities by the FedSell Treasury securities: contractionary.Buy Treasury securities: expansionary.29Two Other Tools of Monetary Policy•Changing reserve requirements.•Changing the discount rate.30Quantity EquationMV=PQ31Money Growth and