ECON 1051 1nd Edition Lecture 50 Outline of Last Lecture I. Story of Multiple Deposit CreationII. Monetary Policy Outline of Current Lecture I. What is Money/Why Do We Need It?II. How Do Banks Create Money?III. The Federal Reserve System IV. The Quantity Theory of Money V. Shadow BankingCurrent LectureI. What is Money/Why Do We Need It?a. The Function of Money i. Medium of Exchange1. Money serves as a medium of exchange when sellers are willing toaccept it in exchange for goods and services ii. Unit of Account1. In a barter system, each good has many pricesiii. Store of Value1. Money allows value to be stored easily. If you do not use all your dollars to buy good and services today, you can hold the rest to use in the future. b. How Money is Measuredi. M1 1. Narrowest definition of the money supply2. The sum of currency in circulation, checking account deposits and holdings of traveler’s checksii. M21. Broader definition2. M1 plus savings account balances, small denomination time deposits, balances in money market deposit accounts in banks andnon-institutional money market fund shares. iii. Two Key PointsThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.1. The money supply consists of both currency and checking account deposits 2. Because balances in checking account deposits are included in themoney supply, banks play an important role in the process by which the way money supply increases and decreaseII. How Do Banks Create Money?a. Reserves i. Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserveb. Required Reservesi. Reserves that a bank is legally required to holdii. Based on its checking deposits c. Required Reserve Ratioi. The minimum fraction of deposits banks are required by law to keep as reserves d. Excess Reserves i. Reserves that banks hold over and above the legal requirement e. The Simple Deposit Multiplier versus the Real-World Deposit Multiplier i. We can summarize these important conclusions1. Whenever banks gain reserves, they make new loans, and the money supply expands2. Whenever banks lose reserves, they reduce their loans, and the money supply contracts III. The Federal Reserve System a. Establishment i. Discount Loans1. Loans the federal reserve makes to banksii. Discount Rate1. The interest rate the federal reserve charge son discount loansb. Fractional Reserve Banking Systemi. A banking system in which banks keep less than 100 percent of deposits as reservesc. Bank Runi. A situation in which many depositors simultaneously decide to withdraw money from a bankd. Bank Panic i. A situation in which many banks experience runs at the same time e. How They Manage Money Supplyi. Open Market Operations1. Federal Open Market Committeea. Responsible for open market operations and managing the money supply in the US2. Open Market Operationsa. The buying and selling of Treasury securities by the FederalReserve in order to control the money supply3. Board of Governorsa. Seven governors appointed by the President for 14 termb. Chair is appointed among one of the governors i. Currently Ben Bernanke ii. Monetary Policy 1. The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomics objectives2. To manage the money supply the Fed uses three monetary policy tools:a. Open market operationsb. Discount Policy i. By lowering the discount rate, the Fed can encourage banks to take additional loans and thereby increase their reserves. With more reserves, banks will make more loans to households and firms, which will increase checking account deposits and the money supply.c. Reserve Requirements i. When the Fed reduces the required reserve ratio, itconverts required reserves into excess reserves.IV. The Quantity Theory of Money a. Money and Prices: The Quantity Equationi. In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection between money and prices using the quantity equation1. M x V = P x Y ii. Velocity of Money 1. The average number of times each dollar in the money supply is used to purchase goods and services included in GDPa. V = (P x Y)/Miii. Quantity Theory of Money 1. A theory about the connection between money and prices that assumes that the velocity of money is constant b. The Quantity Theory Explanation of Inflationi. This equation leads to the following predictions1. If the money supply grows at a faster rate than real GDP, there willbe inflation2. If the money supply grows at a slower rate than real GDP, there will be deflation3. If the money supply grows at the same rate as real GDP, the price level will be stable and there will be neither inflation nor deflationii. High Rates of Inflation1. Hyperinflation a. Very high rates of inflationb. In excess of hundreds of thousands of percentage points per yeari. Economies suffering from high inflation usually alsosuffer from very slow growth, if not severe recession V. Shadow Bankinga. System of non-financial institutions that borrow money in the short-term and take that money to invest in the long-term b. Shadow banking systems avoid banking regulations through the use of credit derivatives c. Can be private lendingi. Especially in Chinad. Shadow banking contributed to the subprime mortgage crisis in
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