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Lecture 8Business Cycles (2)
Money and Monetary System
Se Yan Guanghua School of Management
Peking UniversitySpring 2012
1
Money: definition
MoneyMoney is the stock is the stock of assets that can be of assets that can be readily used to make readily used to make
transactions.transactions.
slide 2
Money: functions1. medium of exchange
we use it to buy stuff2. store of value
transfers purchasing power from the present to the future
3. unit of accountthe common unit by which everyone measures prices and values
slide 3
Liquidity
• Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.
4
Types of Money• Commodity money takes the form of a
commodity with intrinsic value. Examples: Gold, silver, cigarettes
• Fiat money is used as money because of government decree. It does not have intrinsic value. Examples: Coins, currency, check deposits.
5
Currency in Prison
6
cigarettes
Money in the United States Today
• Money in the United States consists of
Currency: the paper bills and coins in the hands of the public.
Deposits at banks and other depository institutions
7
M1 and M2
– The two main official measures of money in the United States are M1 and M2.
– M1 consists of currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses.
– M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.
8
M1 and M2
• This figure illustrates the composition of these two measures in 2003 and shows the relative magnitudes of the components of money.
9
Checks and Credit Cards?
• Checkable deposits are money, but checks are not– checks are instructions to banks to transfer money.
• Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money.
10
Money in China
TypeType AmountAmount
(( 2003.122003.12))DefinitionDefinition
M0 19,746.2亿元(人均 1,969元)
Currency in circulation
M1 84,118.8亿元(人均 8,387元)
M0+
活期存款M2 219,226.8亿元
(人均 21,857元)M1+
定期存款储蓄存款其他存款
11资料来源:中国人民银行统计季报, 2004-1 ,表 2.7(2) , 24-25 页。
M2/GDP in China
12
Depository Institutions
– A depository institution is a firm that accepts deposits from households and firms and uses the deposits to make loans to other households and firms.
– The deposits of three types of depository institution make up the nation’s money:
Commercial banks Thrift institutions Money market mutual funds
13
The Economic Functions of Depository Institutions
• Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans.
• This spread exists because depository institutions Create liquidity Minimize the cost of obtaining funds Minimize the cost of monitoring borrowers Pool risk
14
Reserves: Actual and Required
– The fraction of a bank’s total deposits held as reserves is the reserve ratio.
– The required reserve ratio is the fraction that banks are required, by regulation, to keep as reserves. Required reserves are the total amount of reserves that banks are required to keep.
– Excess reserves equal actual reserves minus required reserves.
15
Creating Deposits by Making Loans
• To see how banks create deposits by making loans, suppose the required reserve ratio is 25 percent.
• A new deposit of $100,000 is made.• The bank keeps $25,000 in reserve and lends $75,000.• This loan is credited to someone’s bank deposit.• The person spends the deposit and another bank now has
$75,000 of extra deposits.• This bank keeps $18,750 on reserve and lends $56,250.
16
How Banks Create Money
• The process continues and keeps repeating with smaller and smaller loans at each “round.”
• This figure illustrates the money creation process.
17
The Money Multiplier
The money multiplier is the reciprocal of the reserve ratio:
M = 1/R
In China a reserve requirement R = 7% The multiplier is 14
18
Bank Panic
Bank Panic in Argentina in 2001
19
The Central Bank
– Partial reserve in depository institutions
– Bank panic: many people withdraw in the same time
– Need an organization to help commercial banks during bank panic
20
Central Bank in China
• The People’s Bank of China, PBOC
• China Bank Regulation Commission
21
国外资产 Foreign Assets163731.
49179720.
25储备货币 Reserve Money
129653.44
133406.64
外汇 Foreign Exchange150784.
95166460.
89 货币发行 Currency Issue
47672.66
40504.78
货币黄金 Monetary Gold 337.24 669.84 金融性公司存款 Deposits of Financial Corporations
81980.78
92901.86
其他国外资产 Other Foreign Assets
12609.31
12589.51
其他存款性公司 Other Depository Corporations
81837.89
92797.95
对政府债权 Claims on Government
16195.99
15676.74
其他金融性公司 Other Financial Corporations
142.9 103.9
其中:中央政府 Of which: Central Government
16195.99
15676.74
不计入储备货币的金融性公司存款 Deposits of financial corporations excluded from Reserve Money
580.49 635.72
对其他存款性公司债权 Claims on Other Depository Corporations
8378.06 7591.72 发行债券 Bond Issue43521.2
139915.6
1
对其他金融性公司债权 Claims on Other Financial Corporations
11852.75
11701国外负债 Foreign Liabilities
771.49 746.92
对非金融性公司债权 Claims on Non-financial Corporations
44.12 43.96政府存款 Deposits of Government
17618.11
27247.71
其他资产 Other Assets 8052.7 7817.24 自有资金 Own Capital 219.75 219.75
总资产 Total Assets208255.
12222550.
91其他负债 Other Liabilities
15890.62
20378.54
总负债 Total Liabilities208255.
12222550.
91
Balance Sheet of PBC 2009
The Federal Reserve System
– The Federal Reserve System, or the Fed, is the central bank of the United States.
– A central bank is the public authority that regulates a nation’s depository institutions and controls the quantity of money.
23
The Federal Reserve System
• The Fed was created in 1914 after a series of bank failures convinced Congress that the U.S. needed a central bank to ensure the health of the nation’s banking system.
24
Do you agree Currency War?
• Can the central bank owned privately?
• Can there be more than one central bank?
• How was paper bill invented in history?
• Why didn’t merchants in Shanxi evolve out to be modern commercial banks?
25
The Structure of the Fed
1) The Board of Governors
2) The Regional Federal Reserve Banks
3) The Federal Open Market Committee
26
The Fed’s Organization
• The Fed is run by a Board of Governors, which has seven members appointed by the President and confirmed by the Senate.
• Among the seven members, the most important is the chairman. The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees.
27
The Federal Open Market Committee (FOMC)
Serves as the main policy-making organ of the Federal Reserve System.
Meets approximately every six weeks to review the economy.
Monetary policy is conducted by the Federal Open Market Committee.28
Three Primary Functions of the Fed• Regulates banks to ensure they follow federal
laws intended to promote safe and sound banking practices.
• Acts as a banker’s bank, making loans to banks and as a lender of last resort.
• Conducts monetary policy by controlling the money supply.
29
Open-Market Operations• The money supply is the quantity of money
available in the economy.• The primary way in which the Fed changes the
money supply is through open-market operations.• The Fed purchases and sells U.S. government
bonds.– To increase the money supply, the Fed buys
government bonds from the public.– To decrease the money supply, the Fed sells
government bonds to the public.
30
Other Tools the Central Bank Can Use• Discount rate
– is the interest rate the Fed charges banks for loans.– Increasing the discount rate decreases the money
supply. – Decreasing the discount rate increases the money
supply.• Required reserve ratio
Increasing the reserve requirement decreases the money supply.
Decreasing the reserve requirement increases the money supply.
31
Problems in Controlling the Money Supply
The Fed’s control of the money supply is not precise.
The Fed must wrestle with two problems The Fed does not control the amount of money that
households choose to hold as deposits in banks. The Fed does not control the amount of money that
bankers choose to lend. In the open economy, it is difficult for the Fed to
control the money supply
32
The Theory of Liquidity Preference
• due to John Maynard Keynes.
• A simple theory in which the interest rate is determined by money supply and money demand.
slide 33
The Demand for Money
• The quantity of money that people plan to hold depends on four main factors
The price level The interest rate Real GDP Financial innovation
34
The Demand for Money Curve
• The demand for money curve is the relationship between the quantity of real money demanded (M/P) and the interest rate when all other influences on the amount of money that people wish to hold remain the same.
35
Money DemandDemand forreal money balances:
slide 36
M/P
real money balances
r
interestrate
sM P
M P
( )d
M P L r
L (r )
Shifts in the Demand for Money Curve
– The demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs.
37
Shifts in the Demand for Money Curve
• The figure illustrates an increase and a decrease in the demand for money.
• A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward.
• An increase in real GDP increases the demand for money and shifts the demand curve rightward.
38
Money Supply
The supply of real money balances is fixed:
slide 39
sM P M P
M/P
real money balances
r
interestrate
sM P
M P
Money Market Equilibrium
– The central bank determines the quantity of money supplied and on any given day, that quantity is fixed.
– The supply of money curve is vertical at the given quantity of money supplied.
– Money market equilibrium determines the interest rate.
40
EquilibriumThe interest rate adjusts to equate the supply and demand for money:
slide 41
M/P
real money balances
r
interestrate
sM P
M P( )M P L r
L (r )
r1
How the Fed raises the interest rate
To increase r, Fed reduces M
slide 42
M/P
real money balances
r
interestrate
1M
P
L (r )
r1
r2
2M
P
The Quantity Theory of Money
– The quantity theory of money is the proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.
– V = PY/M– MV = PY– P = (V/Y)M– The velocity of circulation is the average number
of times in a year a dollar is used to purchase goods and services in GDP.
43
Velocity• basic concept: the rate at which money circulates• definition: the number of times the average dollar
bill changes hands in a given time period• example: In 2001,
• $500 billion in transactions• money supply = $100 billion• The average dollar is used in five transactions in
2001• So, velocity = 5
slide 44
Velocity of Money Circulation
45
Money demand and the quantity equation
• M/P = real money balances, the purchasing power of the money supply.
• A simple money demand function: (M/P )d = k Y
wherek = how much money people wish to hold for each dollar of income. (k is exogenous)
slide 46
Money demand and the quantity equation
• money demand: (M/P )d = k Y
• quantity equation: M V = P Y
• The connection between them: k = 1/V
• When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).
slide 47
The Quantity Theory of Money
– P/P = M/M- Y/Y
– P/P is the inflation rate
– M/M is the growth rate of the quantity of money
– Y/Y is the growth rate of real GDP
48
The Quantity Theory of Money, cont.
Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now).
slide 49
Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.
International data on inflation and money growth
slide 50
Inflation rate(percent, logarithmicscale)
1,000
10,000
100
10
1
0.1
Money supply growth (percent, logarithmic scale)0.1 1 10 100 1,000 10,000
Nicaragua
AngolaBrazil
Bulgaria
Georgia
Kuwait
USA
Japan Canada
Germany
Oman
Democratic Republicof Congo
Inflation and the Price Level
– Inflation is a process in which the price level is rising and money is losing value.
– Inflation is a rise in the price level, not in the price of a particular commodity.
– And inflation is an ongoing process, not a one-time jump in the price level.
51
Inflation and the Price Level
– This figure illustrates the distinction between inflation and a one-time rise in the price level.
52
Hyperinflation
• Hyperinflation is inflation that exceeds 50 percent per month.
• Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.
53
Examples of Hyperinflation
54
Germany
1
100 trillion
1 million
10 billion
1 trillion
100 million
10,000
100
19251924192319221921
Price level
Moneysupply
Poland
Money
supply
Price level
Index (Jan. 1921 = 100)
100
10 million
100,000
1 million
10,000
1,000
19251924192319221921
Index (Jan. 1921 = 100)
Hyperinflation in Germany in the 1920s
55
Ignite the oven with money Money used as wallpaper Basket lost, money still there
Seignorage: The Inflation Tax
• When the government raises revenue by printing money, it is said to levy an inflation tax.
• An inflation tax is like a tax on everyone who holds money.
56
Inflation and interest rates
• Nominal interest rate, inot adjusted for inflation
• Real interest rate, radjusted for inflation:
r = i
slide 57
The Fisher Effect• The Fisher equation: i = r +
• Chap 3: S = I determines r .
• Hence, an increase in causes an equal increase in i.
• This one-for-one relationship is called the Fisher effect.
slide 58
Discussion Question
Why is inflation bad? • What costs does inflation impose on society?
List all the ones you can think of.
• Focus on the long run.
• Think like an economist.
slide 59
A common misperception
• Common misperception: inflation reduces real wages
• This is true only in the short run, when nominal wages are fixed by contracts.
• (Chap 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.
• Consider the data…
slide 60
Average hourly earnings & the CPI
slide 61
0
2
4
6
8
10
12
14
16
18
1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
$ p
er h
ou
r
0
25
50
75
100
125
150
175
200
225
250
CP
I (1
983=
100)
Average hourly
earnings
Hourly earnings in 2001 dollars
Consumer Price Index
0
2
4
6
8
10
12
14
16
18
1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
$ p
er h
ou
r
0
25
50
75
100
125
150
175
200
225
250
CP
I (1
983=
100)
Average hourly
earnings
Hourly earnings in 2001 dollars
Consumer Price Index
The classical view of inflation
• The classical view: A change in the price level is merely a change in the units of measurement.
slide 62
So why, then, is So why, then, is inflation a social inflation a social
problem?problem?
The social costs of inflation
…fall into two categories:
1. costs when inflation is expected
2. additional costs when inflation is different than people had expected.
slide 63
The costs of expected inflation: 1. shoeleather cost
• def: the costs and inconveniences of reducing money balances to avoid the inflation tax.
• i real money balances
• Remember: In long run, inflation doesn’t affect real income or real spending.
• So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.
slide 64
The costs of expected inflation: 2. menu costs
• def: The costs of changing prices.
• Examples:– print new menus– print & mail new catalogs
• The higher is inflation, the more frequently firms must change their prices and incur these costs.
slide 65
The costs of expected inflation: 3. relative price distortions
• Firms facing menu costs change prices infrequently.• Example:
Suppose a firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall.
• Different firms change their prices at different times, leading to relative price distortions…
• …which cause microeconomic inefficiencies in the allocation of resources.
slide 66
The costs of expected inflation: 4. unfair tax treatment
Some taxes are not adjusted to account for inflation, such as the capital gains tax.
Example: 1/1/2001: you bought $10,000 worth of Starbucks
stock 12/31/2001: you sold the stock for $11,000,
so your nominal capital gain was $1000 (10%). Suppose = 10% in 2001.
Your real capital gain is $0. But the govt requires you to pay taxes on your
$1000 nominal gain!!slide 67
The costs of expected inflation: 4. General inconvenience
• Inflation makes it harder to compare nominal values from different time periods.
• This complicates long-range financial planning.
slide 68
Additional cost of unexpected inflation: arbitrary redistributions of purchasing power• Many long-term contracts not indexed,
but based on e.
• If turns out different from e, then some gain at others’ expense.
Example: borrowers & lenders • If > e, then (r ) < (r e)
and purchasing power is transferred from lenders to borrowers.
• If < e, then purchasing power is transferred from borrowers to lenders.
slide 69
Additional cost of high inflation: increased uncertainty
• When inflation is high, it’s more variable and unpredictable: turns out different from e more often, and the differences tend to be larger (though not systematically positive or negative)
• Arbitrary redistributions of wealth become more likely.
• This creates higher uncertainty, which makes risk averse people worse off.
slide 70
One benefit of inflation
• Nominal wages are rarely reduced, even Nominal wages are rarely reduced, even when the equilibrium real wage falls. when the equilibrium real wage falls.
• Inflation allows the real wages to reach Inflation allows the real wages to reach equilibrium levels without nominal wage equilibrium levels without nominal wage cuts.cuts.
• Therefore, moderate inflation improves the Therefore, moderate inflation improves the functioning of labor markets. functioning of labor markets.
• Nominal wages are rarely reduced, even Nominal wages are rarely reduced, even when the equilibrium real wage falls. when the equilibrium real wage falls.
• Inflation allows the real wages to reach Inflation allows the real wages to reach equilibrium levels without nominal wage equilibrium levels without nominal wage cuts.cuts.
• Therefore, moderate inflation improves the Therefore, moderate inflation improves the functioning of labor markets. functioning of labor markets.
slide 71