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We just understood the equilibrium and transmission mechanisms of the goods market.
Now we will analyze the money market…
Topic Textbook chapters
III. MACROECOMIC EQUILIBRIUM IN A FIXED PRICE MODEL: SORT-RUN ANALYSIS A. The goods market B. The money market C. The goods and money markets together (The IS-LM model)
8, 8A, 9, 9A 10, 11 12
IV. MACROECOMIC EQUILIBRIUM IN A FLEXIBLE PRICE MODEL: LONG-RUN ANALYSIS A. Determination of the price level (The AS-AD model) B. Labor Market
13 14
• Overview of money- What is money?
Roles of money (medium of exchange, unit of account, store of value).
- Types of money Commodity money, fiduciary money, fiat money.
- Measuring money M1 and M2
- Should each country has one “official” own money?
• Money supply
- Institutions involved in money creation
- Private banks
- Central BankOpen market operations, required reserve ratio, discount rate
- Supply curve of money
Overview of money• What is money?
-- Medium of exchange (quintessential function):
What sellers generally accept and buyers generally use to pay for
goods and services.
A monetary economy is welfare improving compared with barter economy because it avoids mutual coincidence of
wants.
- Unit of account:A standard unit that provides a consistent way of quoting
prices
Example:
- Unit of account:A standard unit that provides a consistent way of quoting prices
Examples:
a) 2 goods: Lunches (L) and cloth (C)
→ 1 relative price: L in terms of unit of C
b) 3 goods: Lunches (L), cloth (C) and wood (W)
→ 3 relative prices: L in terms of unit of C
L in terms of unit of W
C in terms of unit of W
c) n goods: → relative prices
(e.g. n=1000 → 499500 relative prices)
In a monetary economy you just need n prices in terms of money!
2
1nn
- Store of value: An asset that can be used to transport purchasing power fromone time period to another.
- Liquidity of money:The property of money that makes it a good medium of
exchangeas well as a store of value.
• Types of money
- Commodity money:Items used as money that also have intrinsic value in some other use.
- Fiduciary money: Paper money that is backed by precious metals or othercommodities.
- Fiat money:
Paper money that is intrinsically worthless.
• Measuring money
- Remember…
Money is an asset that is issued to: i) buy things (medium of exchange) ii) to hold wealth (store of value) iii) to quote prices (unit of account)
- What is money and what is not?
Coins and currency money Checking account
Traveler’s checksSavings accountsCertificate of deposit
Liquidity
- Different measures of money based on liquidity
M1 = currency held outside banks + checking accounts + + traveler’s checks + other checkable deposits
M2 = M1 + savings accounts + money market accounts + + small certificate of deposits
• Should each country has one “official” own money?
- As a general rule, each country has one “official” own money
US$, Argentinean Peso, Chinese Yuan
- Some countries share a common currency
Euro, East Caribbean dollar, Colonies françaises d'Afrique ("French colonies of
Africa")
- Some countries have not own or shared currency Ecuador (since 2000), Panama
- Some countries have more than one “currency”Argentina 1999-2002 has more than 15 currencies!
Money supply
• Institutions involved in money creation
- Central Bank (e.g. the Federal Reserve in the US): Monetary institution that has the legal authority to issue bills and coins.Among other functions it regulates the banking system and is thelender of last resort.
- Private banks (e.g. Bank of America):
Act as a link between those who have money to lend and thosewho want to borrow money.
• Money supplyCentral bank and Private banks
• Equilibrium in money market Equilibrium interest rate
• Private banks
- Brief review of accounting
- Balance sheet of a typical private bank
- The creation of money
- The money multiplier
• Central Bank- The Central Bank can determine the supply of notes (bills and coins).
- Let us examine the balance sheet of the Central Bank (Fed 2005, millions of US$).
Assets Liabilities
Gold $11,037 Federal reserve notes $729,601Loans to banks 3,330 Deposits:US treasure Bank reserves 26,130securities 724,700 US treasury 4,813
Other liabilities and net worth 60,366
TOTAL $820,910 TOTAL $820,910
- How does the Central Bank controls the money supply?
• If Central Bank wants to ↑Ms creates more reserves there by freeing banks to create additional deposits by making more loans.
If it wants to decrease the money supply, it reduces reserves.
• The Central Bank has available 3 tools:
1) Engaging in open market operations
2) Changing the required reserve ratio
3) Changing the discount rate
1) Engaging in open market operationsThe purchase and sale by the Central Bank of governmentsecurities (bonds) in the open market.
• Example: Central Bank sells gov. securities ↓Ms
∆Ms = money multiplier ∆reserves = 5 * (-5) = -25
$5$5$60Loans( $20)
Currency$80
$0$0Deposits( $25)
$75$15Reserves( $5)
Reserves( $5)
$15$95
LiabilitiesLiabilitiesAssetsLiabilitiesCommercial Banks
PANEL 3Jane Q. PublicFederal Reserve
AssetsAssets
DebtsDeposits( $5)
Securities( $5)
Net WorthSecurities(+ $5)
Note: Money supply (M1) = Currency + Deposits = $155.
$5
$0
Liabilities
$5
$0
Debts$5
Liabilities
$80
Net Worth
Debts
Currency
Net Worth
Securities(+ $5)
Deposits( $5)
AssetsJane Q. Public
Deposits
AssetsJane Q. Public
Deposits( $5)
Deposits
PANEL 2Commercial BanksFederal Reserve
LiabilitiesAssetsLiabilitiesAssets
$95$15Reserves( $5)
Reserves( $5)
$15$95Securities( $5)
$80LoansCurrency$80
Note: Money supply (M1) = Currency + Deposits = $175.
Note: Money supply (M1) = Currency + Deposits = $180.
$5$80LoansCurrency$80$0$100$20ReservesReserves$20$100Securities
LiabilitiesAssetsLiabilitiesAssetsCommercial BanksFederal Reserve
PANEL 1
$5$5$60Loans( $20)
Currency$80
$0$0Deposits( $25)
$75$15Reserves( $5)
Reserves( $5)
$15$95
LiabilitiesLiabilitiesAssetsLiabilitiesCommercial Banks
PANEL 3Jane Q. PublicFederal Reserve
AssetsAssets
DebtsDeposits( $5)
Securities( $5)
Net WorthSecurities(+ $5)
Note: Money supply (M1) = Currency + Deposits = $155.
$5
$0
Liabilities
$5
$0
Debts$5
Liabilities
$80
Net Worth
Debts
Currency
Net Worth
Securities(+ $5)
Deposits( $5)
AssetsJane Q. Public
Deposits
AssetsJane Q. Public
Deposits( $5)
Deposits
PANEL 2Commercial BanksFederal Reserve
LiabilitiesAssetsLiabilitiesAssets
$95$15Reserves( $5)
Reserves( $5)
$15$95Securities( $5)
$80LoansCurrency$80
Note: Money supply (M1) = Currency + Deposits = $175.
Note: Money supply (M1) = Currency + Deposits = $180.
$5$80LoansCurrency$80$0$100$20ReservesReserves$20$100Securities
LiabilitiesAssetsLiabilitiesAssetsCommercial BanksFederal Reserve
PANEL 1
2) Changing the required reserve ratioIncreases (decreases) in the required reserve ratio allows banks to have less (more) deposits with the existing volume of reserves, therefore decreasing (increasing) the supply of money.
• Example: Central Bank reduce reserve ratio from 20% to 12.5% ↑Ms
∆Ms = ∆money multiplier reserves = (8 - 5) * 100 = 300
PANEL 2: REQUIRED RESERVE RATIO = 12.5%
Commercial BanksFederal Reserve
LiabilitiesAssetsLiabilitiesAssets
Deposits$800$100ReservesReserves$100$200Government
(+ $300)$700Loans(+ $300)
Currency$100securities
Note: Money supply (M1) = Currency + Deposits = $900.
Note: Money supply (M1) = Currency + Deposits = $600.
$400LoansCurrency$100securities
Deposits$500$100ReservesReserves$100$200Government
LiabilitiesAssetsLiabilitiesAssets
Commercial BanksFederal Reserve
PANEL 1: REQUIRED RESERVE RATIO = 20%
PANEL 2: REQUIRED RESERVE RATIO = 12.5%
Commercial BanksFederal Reserve
LiabilitiesAssetsLiabilitiesAssets
Deposits$800$100ReservesReserves$100$200Government
(+ $300)$700Loans(+ $300)
Currency$100securities
Note: Money supply (M1) = Currency + Deposits = $900.
Note: Money supply (M1) = Currency + Deposits = $600.
$400LoansCurrency$100securities
Deposits$500$100ReservesReserves$100$200Government
LiabilitiesAssetsLiabilitiesAssets
Commercial BanksFederal Reserve
PANEL 1: REQUIRED RESERVE RATIO = 20%
3) Changing the discount rate (interest rate that banks pay to the Central Bank to borrow from it)
discount rate ↑cost of borrowing ↓loans to banks ↓reserves ↓Ms
• Example: Central Bank ↓discount rate ↑Ms
∆Ms = money multiplier ∆reserves money multiplier ∆loans = 5 * 20 = 100
PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED
Commercial BanksFederal Reserve
LiabilitiesAssetsLiabilitiesAssets
Deposits(+ $100)
$500$100Reserves(+ $20)
Reserves(+ $20)
$100$160Securities
Amount owed to Fed (+ $20)
$20$420Loans(+ $100)
Currency$80$20Loans
Note: Money supply (M1) = Currency + Deposits = $580.
Note: Money supply (M1) = Currency + Deposits = $480.
$320LoansCurrency$80
Deposits$400$80ReservesReserves$80$160Securities
LiabilitiesAssetsLiabilitiesAssets
Commercial BanksFederal Reserve
PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED
PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED
Commercial BanksFederal Reserve
LiabilitiesAssetsLiabilitiesAssets
Deposits(+ $100)
$500$100Reserves(+ $20)
Reserves(+ $20)
$100$160Securities
Amount owed to Fed (+ $20)
$20$420Loans(+ $100)
Currency$80$20Loans
Note: Money supply (M1) = Currency + Deposits = $580.
Note: Money supply (M1) = Currency + Deposits = $480.
$320LoansCurrency$80
Deposits$400$80ReservesReserves$80$160Securities
LiabilitiesAssetsLiabilitiesAssets
Commercial BanksFederal Reserve
PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED