March 3rd – March 5th, 2015 Chapter 4: The Monetary System In This Chapter, You Will Learn - The definition, functions, and types of money - How banks “create” money - What a central bank is and how it controls the money supply Money on the Island of Yap - An interesting money story - Think about these questions: o What is money? o What functions does money serve? o Who creates money? o Why does the value of money change?- Country: Micronesia - Land: about 40 sq miles - Population: about 6000Stone Money - 19th century observations - Stone money - Sizes of money: range from pocket size to 12 feet in diameter - Production of stone: o The stones are not local o Need to be quarried and transported from the island of Palau 250 miles away o The production process involves tremendous difficulty, sometimes loss of lives o Expedition order issued by chief, who would get all large stones plus 2/5 of smallones - 1882: British naturalist reported seeing 400 men working on the stones (think about thepopulation) - Curious: the stone has no other use, not used for worship, or decoration - How the value of money is determined: o Not entirely known o Size matters o The cost and difficulty in production process - Interesting observation 1: o Record keeping system - Interesting observation 2: inflation o David O’Keefe, late 19th century o Whole vessel of stones in exchange for coprao 13,000 stones found in 1920s o Stones became almost worthless Money - In most countries, gold and silver were the commonly accepted form of money before modern times - Interesting fact: money did not come about as a government decree, but emerged from market transactions - Why did money emerge? - Why did people need money? Difficulties of a barter economy - Consider a barter economy in which goods are exchanged for other goods - An economics professor who wants bread will have to find a baker who is willing to listento his lectures - Without such double coincidence of wants, the professor will have to be starved - Solution: medium of exchange, something that everybody accepts as a means of payment - In a barter economy, prices are relative prices. Example: two loafs of bread per economiclecture - With 3 goods, economic lectures, movies and peaches, there will be 3 relative prices: theprice of peaches in terms of lectures, the price of lectures in terms of movies, and the price of peaches in terms of movies - With 4 goods, how many relative prices do we need? - We need 6- What about 10? - With N goods, we need N(N-1)/2 relative prices Money as medium of exchange - Money is used to pay for goods and services - Money reduces transaction costs and improves economic efficiency by serving as a medium of exchange Money as a unit of account - With a unit of account, the value of goods can be stated much clearly and easily - Money serves as the unit of account - With 100 goods, we need precisely 100 prices - Money reduces transaction costs by serving as unit of account Money as store of value - Store of value: a repository of purchasing power over time - Money is not the best store of value in terms of the rate of return: stocks and bonds often offer better returns- Why do people still use money as store of value?- Money is the most liquid form of store of value - How good a store of value money is depends on the inflation rate. Banks’ role in the monetary system- The money supply equals currency plus demand (checking account) deposits: M = C + D - Since the money supply includes demand deposits, the banking system plays an important role - To understand the role of banks, we will consider three scenarios: o No banks o 100-percent-reserve banking (banks hold all deposits as reserves) o Fractional-reserve banking (banks hold a fraction of deposits as reserves, using the rest to make loans) - In each scenario, we assume C = $1,000 Bank capital, leverage, and capital requirements - Being highly leveraged makes banks vulnerable - Example: Suppose a recession causes our bank’s assets to fall by 5%, to $950 - Then, capital = assets – liabilities = 950 – 950 = 0 - 2008 – 2009 financial crisis: o Losses on mortgages shrank bank capital, slowed lending, exacerbated the recession o Gov’t injected $ billions of capital into banks to ease the crisis and encourage more lending A few preliminaries - A bank’s liabilities include deposits; assets include reserves and outstanding loans Scenario 1: No banks - With no banks, D = 0, and M = C = $1,000- In this case, money supply = total amount of currency - Increasing money supply = printing more dollar bills Scenario 2: 100-percent-reserve banking - Initially C = $1000, D = $0, M = $1,000- Now suppose households deposit the $1,000 at “Firstbank” - After the deposit: o C = $0 o D = $1,000o M = $1,000- Lesson: 100%-reserve banking has no impact on size of money supplyScenario 3: Fractional-reserve banking - Suppose banks hold 20% of deposits in reserve, making loans with the rest - Firstbank will make $800 in loans - The money supply now equals $1,800 o Depositor has $1,000 in demand deposits o Borrower holds $800 in currency - Lesson: in a fractional-reserve banking system, banks create money - Suppose the borrower deposits the $800 in Secondbank - Initially, Secondbank’s balance sheet- Seconbank will loan 80% of this deposit - If this $640 is eventually deposited in Thirdbank then Thirdbank will keep 20% of it in reserve and loan the rest out Finding the total amount of money- Original deposit + Firstbank lending + Secondbank lending + Thirdbank lending + other lending - $1000 + $800 + $640 + $512- Total money supply = (1/rr) x $1,000 where rr = ratio of reserves to deposits - In our example, rr = 0.2, so M = $5,000Money creation in the banking system - A fractional-reserve banking system creates money, but it doesn’t create wealth: - Bank loans give borrowers some new money and an equal amount of new debt A model of the money supply - How does the Fed control the total amount of money (money supply) in the economy? - Next, we look at a model that relates the monetary base to a total money supply. - Monetary base: currencies + total bank reserves - The Fed can directly control the monetary base - Fed to monetary base to money supply - Exogenous Variables Now You Try - M = m x B, where m = (cr+1)/ (cr+rr) - Suppose households decide to hold more of their money as currency and less in the form of demand deposits. o Determine impact on money supply o Explain the