CHAPTER 22
What role does money play in the economy?©Mmaxer/Shutterstock
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Discuss the three functions of money and how the money supply is measured.
2. LO2Analyze how the lending behavior of commercial banks affects the money supply.
3. LO3Describe the structure and responsibilities of the Federal Reserve System.
4. LO4Explain why control of the money supply is important and how the money supply is related to inflation in the long run.
You have probably heard expressions such as “on the money,” “smart money,” “time is money,” “money talks,” and “put your money where your mouth is.” When people use the word money, they often mean something different than what economists mean when they use the word. For an economist, when you get a paycheck, you are receiving income, and any amount that you do not spend on current consumption is saving. Or think about someone who has done well in the stock market: Most people would say that they “made money” in the market. No, an economist would answer, their wealth increased. These terms don’t make for a catchy expression, but a good economic naturalist must use words like income, saving, wealth, and money carefully because each plays a different role in the financial system.
In this chapter, we discuss the role of money in modern economies: why it is important, how it is measured, and how it is created. Money plays a major role in everyday economic transactions but, as we will see, it is also quite important at the macro level. For example, as we mentioned in Chapter 16, Macroeconomics: The Bird’s-Eye View of the Economy, one of the three main types of macroeconomic policy, monetary policy, relates primarily to decisions about how much money should be allowed to circulate in the economy. In the United States, monetary policy is made by the Federal Reserve, the nation’s central bank. Because the Federal Reserve, or Fed, determines the nation’s money supply, this chapter also introduces the Fed and discusses some of the policy tools at its disposal. Finally, the chapter discusses the important relationship between the amount of money in circulation and the rate of inflation in an economy.
MONEY AND ITS USES
What exactly is money? To the economist, money is any asset that can be used in making purchases. Common examples of money in the modern world are currency and coin. A checking account balance represents another asset that can be used in making payments (as when you write a check to pay for your weekly groceries) and so is also counted as money. In contrast, shares of stock, for example, cannot be used directly in most transactions. Stock must first be sold—that is, converted into cash or a checking account deposit—before further transactions, such as buying your groceries, can be made.
Historically, a wide variety of objects have been used as money, including cacao beans (used by the Aztec people, who dominated central Mexico until the coming of the Spanish in the sixteenth century), gold and silver coins, shells, beads, feathers, and, on the island of Yap, large, immovable boulders. Prior to the use of metallic coins, by far the most common form of money was the cowrie, a type of shell found in the South Pacific. Cowries were used as money in some parts of Africa until very recently, being officially accepted for payment of taxes in Uganda until the beginning of the twentieth century. Today, money can be virtually intangible, as in the case of your checking account.
Why do people use money? Money has three principal uses: a medium of exchange, a unit of account, and a store of value.
Money serves as a medium of exchange when it is used to purchase goods and services, as when you pay cash for a newspaper or write a check to cover your utilities bill. This is perhaps money’s most crucial function. Think about how complicated daily life would become if there were no money. Without money, all economic transactions would have to be in the form of barter, which is the direct trade of goods or services for other goods or services.
Barter is highly inefficient because it requires that each party to a trade has something that the other party wants, a so-called double coincidence of wants. For example, under a barter system, a musician could get her dinner only by finding someone willing to trade food for a musical performance. Finding such a match of needs, where each party happens to want exactly what the other person has to offer, would be difficult to do on a regular basis. In a world with money, the musician’s problem is considerably simpler. First, she must find someone who is willing to pay money for her musical performance. Then, with the money received, she can purchase the food and other goods and services that she needs. In a society that uses money, it is not necessary that the person who wants to hear music and the person willing to provide food to the musician be one and the same. In other words, there need not be a double coincidence of wants for trades of goods and services to take place.
In a world without money, he could eat only by finding someone willing to trade food for a musical performance.©DreamPictures/Jensen Walker/ Blend Images
By eliminating the problem of having to find a double coincidence of wants in order to trade, the use of money in a society permits individuals to specialize in producing particular goods or services, as opposed to having every family or village produce most of what it needs. Specialization greatly increases economic efficiency and material standards of living, as discussed in Chapter 2, Comparative Advantage, when we developed the Principle of Comparative Advantage. This usefulness of money in making transactions explains why savers hold money, even though money generally pays a low rate of return. Cash, for example, pays no interest at all, and the balances in checking accounts usually pay a lower rate of interest than could be obtained in alternative financial investments.
Comparative Advantage
Money’s second function is as a unit of account. As a unit of account, money is the basic yardstick for measuring economic value. In the United States, virtually all prices—including the price of labor (wages) and the prices of financial assets, such as shares of General Motors stock—are expressed in dollars. Expressing economic values in a common unit of account allows for easy comparisons. For example, grain can be measured in bushels and coal in tons, but to judge whether 20 bushels of grain is economically more or less valuable than a ton of coal, we express both values in dollar terms. The use of money as a unit of account is closely related to its use as a medium of exchange; because money is used to buy and sell things, it makes sense to express prices of all kinds in money terms.
As a store of value, its third function, money is a way of holding wealth. For example, the miser who stuffs cash in his mattress or buries gold coins under the old oak tree at midnight is holding wealth in money form. Likewise, if you regularly keep a balance in your checking account, you are holding part of your wealth in the form of money. Although money is usually the primary medium of exchange or unit of account in an economy, it is not the only store of value. There are numerous other ways of holding wealth, such as owning stocks, bonds, or real estate.
For most people, money is not a particularly good way to hold wealth, apart from its usefulness as a medium of exchange. Unlike government bonds and other types of financial assets, most forms of money pay no interest, and there is always the risk of cash being lost or stolen. However, cash has the advantage of being anonymous and difficult to trace, making it an attractive store of value for smugglers, drug dealers, and others who want their assets to stay out of the view of the Internal Revenue Service.
The Economic Naturalist 22.1
From Ithaca Hours to Bitcoin: what is private money, communally created money, and open-source money?
Since money is such a useful tool, why is money usually issued only by governments? Are there examples of privately issued, or communally created, money?
Money is usually issued by the government, not private individuals, but in part, this reflects legal restrictions on private money issuance. Where the law allows, private moneys do sometimes emerge.1 For example, privately issued currencies circulate in more than 30 U.S. communities. In Ithaca, New York, a private currency known as “Ithaca Hours” has circulated since 1991. Instituted by town resident Paul Glover, each Ithaca Hour is equivalent to $10, the average hourly wage of workers in the county. The bills, printed with specially developed inks to prevent counterfeiting, honor local people and the environment. An estimated 1,600 individuals and businesses have earned and spent Hours. Founder Paul Glover argues that the use of Hours, which can’t be spent elsewhere, induces people to do more of their shopping in the local economy.
A more recent development in private money was the emergence of the virtual currency known as “Bitcoin” in 2009. This is a peer-to-peer, open-source online payment system without a central administrator, where payments are recorded in a public ledger using Bitcoin as the unit of account. New bitcoins are created as a reward for payment-processing work, known as mining, in which users offer their computing power to verify and record payments into the public ledger. Already circulating bitcoins can be obtained in exchange for other currencies, products, and services. Users can send and receive bitcoins electronically using special wallet software on a personal computer, mobile device, or web application. As of mid-September, 2017, the value of one bitcoin was around US$3,500, with more than 16.5 million bitcoins in circulation.
Despite its promise as a decentralized digital currency, Bitcoin has not been very successful as a money so far, and it is not widely accepted for most transactions. The relatively small commercial use of Bitcoin compared to its use by speculators has contributed to significant price volatility. In a famous episode, in November 2013 one bitcoin traded for more than $1,100—more than 10 times its price in dollars a few months earlier—before sharply declining and trading for less than $300 during much of 2015. In late 2015, the digital currency started climbing in value again, reaching an all-time high of more than $5,000 per one bitcoin on September 1, 2017—before falling to around $4,500 the next day and to around $3,500 later that month. This volatility limits Bitcoin’s ability to act as a stable store of value and as a reliable unit of account in which prices could be quoted—two of the three principal uses of money described earlier in this chapter.
What do Ithaca Hours and Bitcoin have in common? By functioning as a medium of exchange, each facilitates trade within a community.
MEASURING MONEY
How much money, defined as financial assets usable for making purchases, is there in the U.S. economy at any given time? This question is not simple to answer because, in practice, it is not easy to draw a clear distinction between those assets that should be counted as money and those that should not. Dollar bills are certainly a form of money, and a van Gogh painting certainly is not. However, brokerage firms now offer accounts that allow their owners to combine financial investments in stocks and bonds with check-writing and credit card privileges. Should the balances in these accounts, or some part of them, be counted as money? It is difficult to tell.
Economists skirt the problem of deciding what is and isn’t money by using several alternative definitions of money, which vary in how broadly the concept of money is defined. A relatively “narrow” definition of the amount of money in the U.S. economy is called M1; it is the sum of currency outstanding and balances held in checking accounts. A broader measure of money, called M2, includes all the assets in M1 plus some additional assets that are usable in making payments, but at greater cost or inconvenience than currency or checks. Table 22.1 lists the components of M1 and M2 and also gives the amount of each type of asset outstanding as of July 2017. For most purposes, however, it is sufficient to think of money as the sum of currency outstanding and balances in checking accounts, or M1.
Note that credit card balances are not included in either M1 or M2 even though people increasingly use credit cards to pay for many of their purchases, including food, clothing, and even college tuition. The main reason credit card balances are not included in the money supply is that they do not represent part of people's wealth. Indeed, a credit card charge of $1,000 represents an obligation to pay someone else $1,000.
RECAP
MONEY AND ITS USES
· Money is any asset that can be used in making purchases, such as currency or a checking account. Money serves as a medium of exchange when it is used to purchase goods and services. The use of money as a medium of exchange eliminates the need for barter and the difficulties of finding a “double coincidence of wants.” Money also serves as a unit of account and a store of value.
· In practice, two basic measures of money are M1 and M2. M1, a more narrow measure, is made up primarily of currency and balances held in checking accounts. The broader measure, M2, includes all the assets in M1 plus some additional assets usable in making payments.
· Credit card balances are never counted as or considered money because credit card balances are merely obligations to pay others.
COMMERCIAL BANKS AND THE CREATION OF MONEY
What determines the amount of money in the economy? If the economy’s supply of money consisted entirely of currency, the answer would be simple: The supply of money would just be equal to the value of the currency created and circulated by the government. However, as we have seen, in modern economies the money supply consists not only of currency but also of deposit balances held by the public in commercial, that is, private, banks. The determination of the money supply in a modern economy thus depends in part on the behavior of commercial banks and their depositors.
To see how the existence of commercial banks affects the money supply, we will use the example of a fictional country, the Republic of Gorgonzola. Initially, we assume, Gorgonzola has no commercial banking system. To make trading easier and eliminate the need for barter, the government directs the central bank of Gorgonzola to put into circulation a million identical paper notes, called guilders. The central bank prints the guilders and distributes them to the populace. At this point, the Gorgonzolan money supply is a million guilders.
However, the citizens of Gorgonzola are unhappy with a money supply made up entirely of paper guilders since the notes may be lost or stolen. In response to the demand for safekeeping of money, some Gorgonzolan entrepreneurs set up a system of commercial banks. At first, these banks are only storage vaults where people can deposit their guilders. When people need to make a payment they can either physically withdraw their guilders or, more conveniently, write a check on their account.
Checks give the banks permission to transfer guilders from the account of the person paying by check to the account of the person to whom the check is made out. With a system of payments based on checks the paper guilders need never leave the banking system, although they flow from one bank to another as a depositor of one bank makes a payment to a depositor in another bank. Deposits do not pay interest in this economy; indeed, the banks can make a profit only by charging depositors fees in exchange for safeguarding their cash.
Let’s suppose for now that people prefer bank deposits to cash and so deposit all of their guilders with the commercial banks. With all guilders in the vaults of banks, the balance sheet of all of Gorgonzola’s commercial banks taken together is as shown in Table 22.2.
The assets of the commercial banking system in Gorgonzola are the paper guilders sitting in the vaults of all the individual banks. The banking system’s liabilities are the deposits of the banks’ customers, since checking account balances represent money owed by the banks to the depositors.
Cash or similar assets held by banks are called bank reserves. In this example, bank reserves, for all the banks taken together, equal 1,000,000 guilders—the currency listed on the asset side of the consolidated balance sheet. Banks hold reserves to meet depositors’ demands for cash withdrawals or to pay checks drawn on their depositors’ accounts. In this example, the bank reserves of 1,000,000 guilders equal 100 percent of banks’ deposits, which are also 1,000,000 guilders. A situation in which bank reserves equal 100 percent of bank deposits is called 100 percent reserve banking.
Bank reserves are held by banks in their vaults, rather than circulated among the public, and thus are not counted as part of the money supply. However, bank deposit balances, which can be used in making transactions, are counted as money. So, after the introduction of “safekeeper” banks in Gorgonzola, the money supply, equal to the value of bank deposits, is 1,000,000 guilders, which is the same as it was prior to the introduction of banks.
To continue the story, after a while the commercial bankers of Gorgonzola begin to realize that keeping 100 percent reserves against deposits is not necessary. True, a few guilders flow in and out of the typical bank as depositors receive payments or write checks, but for the most part the stacks of paper guilders just sit there in the vaults, untouched and unused. It occurs to the bankers that they can meet the random inflow and outflow of guilders to their banks with reserves that are less than 100 percent of their deposits. After some observation, the bankers conclude that keeping reserves equal to only 10 percent of deposits is enough to meet the random ebb and flow of withdrawals and payments from their individual banks. The remaining 90 percent of deposits, the bankers realize, can be lent out to borrowers to earn interest.
So the bankers decide to keep reserves equal to 100,000 guilders, or 10 percent of their deposits. The other 900,000 guilders they lend out at interest to Gorgonzolan cheese producers who want to use the money to make improvements to their farms. After the loans are made, the balance sheet of all of Gorgonzola’s commercial banks taken together has changed, as shown in Table 22.3.
After the loans are made, the banks’ reserves of 100,000 guilders no longer equal 100 percent of the banks’ deposits of 1,000,000 guilders. Instead, the reserve-deposit ratio, which is bank reserves divided by deposits, is now equal to 100,000/1,000,000, or 10 percent. A banking system in which banks hold fewer reserves than deposits so that the reserve-deposit ratio is less than 100 percent is called a fractional-reserve banking system.
Notice that 900,000 guilders have flowed out of the banking system (as loans to farmers) and are now in the hands of the public. But we have assumed that private citizens prefer bank deposits to cash for making transactions. So ultimately people will redeposit the 900,000 guilders in the banking system. After these deposits are made, the consolidated balance sheet of the commercial banks is as in Table 22.4.
Note that bank deposits, and hence the economy’s money supply, now equal 1,900,000 guilders. In effect, the existence of the commercial banking system has permitted the creation of new money. These deposits, which are liabilities of the banks, are balanced by assets of 1,000,000 guilders in reserves and 900,000 guilders in loans owed to the banks. The fractional-reserve commercial banking system has thus led to the creation of additional money over and above the initial 1,000,000 guilders in currency.
However, the story does not end here. On examining their balance sheets, the bankers are surprised to see that they once again have “too many” reserves. With deposits of 1,900,000 guilders and a 10 percent reserve-deposit ratio, they need only 190,000 guilders in reserves. But they have 1,000,000 guilders in reserves—810,000 too many. Since lending out their excess guilders is always more profitable than leaving them in the vault, the bankers proceed to make another 810,000 guilders in loans. Eventually these loaned-out guilders are redeposited in the banking system, after which the consolidated balance sheet of the banks is as shown in Table 22.5.
Now the money supply has increased to 2,710,000 guilders, equal to the value of bank deposits. Despite the expansion of loans and deposits, however, the bankers find that their reserves of 1,000,000 guilders still exceed the desired level of 10 percent of deposits, which are 2,710,000 guilders. And so yet another round of lending will take place.
CONCEPT CHECK 22.1
Determine what the balance sheet of the banking system of Gorgonzola will look like after a third round of lending to farmers and redeposits of guilders into the commercial banking system. What is the money supply at that point?
The process of expansion of loans and deposits will only end when reserves equal 10 percent of bank deposits, because as long as reserves exceed 10 percent of deposits the banks will find it profitable to lend out the extra reserves. Since reserves at the end of every round equal 1,000,000 guilders, for the reserve-deposit ratio to equal 10 percent, total deposits must equal 10,000,000 guilders. Further, since the balance sheet must balance, with assets equal to liabilities, we know as well that at the end of the process loans to cheese producers must equal 9,000,000 guilders. If loans equal 9,000,000 guilders, then bank assets, the sum of loans and reserves (1,000,000 guilders), will equal 10,000,000 guilders, which is the same as bank liabilities (bank deposits). The final consolidated balance sheet is as shown in Table 22.6.
The money supply, which is equal to total deposits, is 10,000,000 guilders at the end of the process. We see that the existence of a fractional-reserve banking system has multiplied the money supply by a factor of 10, relative to the economy with no banks or the economy with 100 percent reserve banking. Put another way, with a 10 percent reserve-deposit ratio, each guilder deposited in the banking system can “support” 10 guilders worth of deposits.
To find the money supply in this example more directly, we observe that deposits will expand through additional rounds of lending as long as the ratio of bank reserves to bank deposits exceeds the reserve-deposit ratio desired by banks. When the actual ratio of bank reserves to deposits equals the desired reserve-deposit ratio, the expansion stops. So ultimately, deposits in the banking system satisfy the following relationship:
This equation can be rewritten to solve for bank deposits:
(22.1)
In Gorgonzola, since all the currency in the economy flows into the banking system, bank reserves equal 1,000,000 guilders. The reserve-deposit ratio desired by banks is 0.10. Therefore, using Equation 22.1, we find that bank deposits equal (1,000,000 guilders)/0.10, or 10 million guilders, the same answer we found in the consolidated balance sheet of the banks, Table 22.6.
CONCEPT CHECK 22.2
Find deposits and the money supply in Gorgonzola if the banks’ desired reserve-deposit ratio is 5 percent rather than 10 percent. What if the total amount of currency circulated by the central bank is 2,000,000 guilders and the desired reserve-deposit ratio remains at 10 percent?
THE MONEY SUPPLY WITH BOTH CURRENCY AND DEPOSITS
In the example of Gorgonzola, we assumed that all money is held in the form of deposits in banks. In reality, of course, people keep only part of their money holdings in the form of bank accounts and hold the rest in the form of currency. Fortunately, allowing for the fact that people hold both currency and bank deposits does not greatly complicate the determination of the money supply, as Example 22.1 shows.
EXAMPLE 22.1The Money Supply with Both Currency and Deposits
What is the money supply in Gorgonzola when there are both currency and bank deposits?
Suppose that the citizens of Gorgonzola choose to hold a total of 500,000 guilders in the form of currency and to deposit the rest of their money in banks. Banks keep reserves equal to 10 percent of deposits. What is the money supply in Gorgonzola?
The money supply is the sum of currency in the hands of the public and bank deposits. Currency in the hands of the public is given as 500,000 guilders. What is the quantity of bank deposits? Since 500,000 of the 1,000,000 guilders issued by the central bank are being used by the public in the form of currency, only the remaining 500,000 guilders are available to serve as bank reserves. We know that deposits equal bank reserves divided by the reserve-deposit ratio, so deposits are 500,000 guilders/0.10 = 5,000,000 guilders. The total money supply is the sum of currency in the hands of the public (500,000 guilders) and bank deposits (5,000,000 guilders), or 5,500,000 guilders.
We can write a general relationship that captures the reasoning of this example. First, let’s write out the fact that the money supply equals currency plus bank deposits:
Money supply = Currency held by the public + Bank deposits.
We also know that bank deposits equal bank reserves divided by the reserve-deposit ratio that is desired by commercial banks (Equation 22.1). Using that relationship to substitute for bank deposits in the expression for the money supply, we get
(22.2)
We can use Equation 22.2 to confirm our answer to Example 22.1. In that example, currency held by the public is 500,000 guilders, bank reserves are 500,000 guilders, and the desired reserve-deposit ratio is 0.10. Plugging these values into Equation 22.2, we get that the money supply equals 500,000 + 500,000/0.10 = 5,500,000, the same answer we found before.
EXAMPLE 22.2The Money Supply at Christmas
How does Christmas shopping affect the money supply?
During the Christmas season people choose to hold unusually large amounts of currency for shopping. With no action by the central bank, how would this change in currency holding affect the national money supply?
To illustrate with a numerical example, suppose that initially bank reserves are 500, the amount of currency held by the public is 500, and the desired reserve-deposit ratio in the banking system is 0.2. Inserting these values into Equation 22.2, we find that the money supply equals 500 + 500/0.2 = 3,000.
Now suppose that because of Christmas shopping needs, the public increases its currency holdings to 600 by withdrawing 100 from commercial banks. These withdrawals reduce bank reserves to 400. Using Equation 22.2 we find now that the money supply is 600 + 400/0.2 = 2,600. So the public’s increased holdings of currency have caused the money supply to drop, from 3,000 to 2,600. The reason for the drop is that with a reserve-deposit ratio of 20 percent, every dollar in the vaults of banks can “support” $5 of deposits and hence $5 of money supply. However, the same dollar in the hands of the public becomes $1 of currency, contributing only $1 to the total money supply. So when the public withdraws cash from the banks, the overall money supply declines. (We will see in the next section, however, that in practice the central bank has means to offset the impact of the public’s actions on the money supply.)
RECAP
COMMERCIAL BANKS AND THE CREATION OF MONEY
· Part of the money supply consists of deposits in private commercial banks. Hence the behavior of commercial banks and their depositors helps to determine the money supply.
· Cash or similar assets held by banks are called bank reserves. In modern economies, banks’ reserves are less than their deposits, a situation called fractional-reserve banking. The ratio of bank reserves to deposits is called the reserve-deposit ratio; in a fractional-reserve banking system, this ratio is less than 1.
· The portion of deposits not held as reserves can be lent out by the banks to earn interest. Banks will continue to make loans and accept deposits as long as the reserve-deposit ratio exceeds its desired level. This process stops only when the actual and desired reserve-deposit ratios are equal. At that point, total bank deposits equal bank reserves divided by the desired reserve-deposit ratio, and the money supply equals the currency held by the public plus bank deposits.
THE FEDERAL RESERVE SYSTEM
For participants in financial markets and the average citizen as well, one of the most important branches of the government is the Federal Reserve System, often called the Fed. The Fed is the central bank of the United States. Like central banks in other countries, the Fed has two main responsibilities.
First, it is responsible for monetary policy, which means that the Fed determines how much money circulates in the economy. As we will see in later chapters, changes in the supply of money can affect many important macroeconomic variables, including interest rates, inflation, unemployment, and exchange rates. Because of its ability to affect key variables, particularly financial variables such as interest rates, financial market participants pay close attention to Fed actions and announcements. As a necessary first step in understanding how Fed policies have the effects that they do, in this chapter we will focus on the basic question of how the Fed affects the supply of money, leaving for later the explanation of why changes in the money supply affect the economy.
Second, along with other government agencies, the Federal Reserve bears important responsibility for the oversight and regulation of financial markets. The Fed also plays a major role during periods of crisis in financial markets. To lay the groundwork for discussing how the Fed carries out its responsibilities, we first briefly review the history and structure of the Federal Reserve System.
THE HISTORY AND STRUCTURE OF THE FEDERAL RESERVE SYSTEM
The Federal Reserve System was created by the Federal Reserve Act, passed by Congress in 1913, and began operations in 1914. Like all central banks, the Fed is a government agency. Unlike commercial banks, which are private businesses whose principal objective is making a profit, central banks like the Fed focus on promoting public goals such as economic growth, low inflation, and the smooth operation of financial markets.
The Federal Reserve Act established a system of 12 regional Federal Reserve banks, each associated with a geographical area called a Federal Reserve district. Congress hoped that the establishment of Federal Reserve banks around the country would ensure that different regions were represented in the national policymaking process. In fact, the regional Feds regularly assess economic conditions in their districts and report this information to policymakers in Washington. Regional Federal Reserve banks also provide various services, such as check-clearing services, to the commercial banks in their district.
At the national level, the leadership of the Federal Reserve System is provided by its Board of Governors. The Board of Governors, together with a large professional staff, is located in Washington, D.C. The Board consists of seven governors, who are appointed by the president of the United States to 14-year terms. The terms are staggered so that one governor comes up for reappointment every other year. The president also appoints one of these Board members to serve as chair of the Board of Governors for a term of four years. The Fed chair, along with the secretary of the Treasury, is probably one of the two most powerful economic policymakers in the United States government, after the president. Recent Fed chairs include Paul Volcker (1979–1987), Alan Greenspan (1987–2006), Ben Bernanke (2006–2014), Janet Yellen (2014–2018), and Jerome Powell (2018-present).
Decisions about monetary policy are made by a 12-member committee called the Federal Open Market Committee (FOMC). The FOMC consists of the seven Fed governors, the president of the Federal Reserve Bank of New York, and four of the presidents of the other regional Federal Reserve banks, who serve on a rotating basis. The FOMC meets approximately eight times a year to review the state of the economy and to determine monetary policy.
CONTROLLING THE MONEY SUPPLY: OPEN-MARKET OPERATIONS
The Fed’s primary responsibility is making monetary policy, which involves decisions about the appropriate size of the nation’s money supply. As we saw in the previous section, central banks in general, and the Fed in particular, do not control the money supply directly. However, they can control the money supply indirectly by changing the supply of reserves held by commercial banks.
The Fed has several ways of affecting the supply of bank reserves. Historically, the most important of these is open-market operations. Suppose that the Fed wants to increase bank reserves, with the ultimate goal of increasing bank deposits and the money supply. To accomplish this, the Fed buys financial assets, usually government bonds, from the public. The people who sell the bonds to the Fed will deposit the proceeds they receive as payment for their bonds in commercial banks. Thus, the reserves of the commercial banking system will increase by an amount equal to the value of the bonds purchased by the Fed. The increase in bank reserves will lead in turn, through the process of lending and redeposit of funds described in the previous section, to an expansion of bank deposits and the money supply, as summarized by Equation 22.2. The Fed’s purchase of government bonds from the public, with the result that bank reserves and the money supply are increased, is called an open-market purchase.
To reduce bank reserves and hence the money supply, the Fed reverses the procedure. It sells some of the government bonds that it holds (acquired in previous open-market purchases) to the public. Assume that the public pays for the bonds by writing checks on their accounts in commercial banks. Then, when the Fed presents the checks to the commercial banks for payment, reserves equal in value to the government bonds sold by the Fed are transferred from the commercial banks to the Fed. The Fed retires these reserves from circulation, lowering the supply of bank reserves and, hence, the overall money supply. The sale of government bonds by the Fed to the public for the purpose of reducing bank reserves and hence the money supply is called an open-market sale. Open-market purchases and sales together are called open-market operations.
Open-market operations are the most convenient and flexible tool that the Federal Reserve has for affecting the money supply if we assume, as we have in this chapter, that banks always act to maintain a desired reserve-deposit ratio that never changes. In such a state of affairs, banks always attempt to avoid holding “too many” or “too few” reserves relative to that (never-changing) desired ratio. Changes in reserves caused by open-market operations are therefore immediately translated by banks into changes in lending conditions and the supply of money. Until the 2007–2008 financial crisis, things worked roughly this way, and open-market operations were employed on a regular basis for controlling the money supply. The details and purpose of open-market operations changed following the crisis, as we will discuss in later chapters. In that discussion, we will also introduce additional means by which the Fed can affect the money supply.
EXAMPLE 22.3Increasing the Money Supply by Open-Market Operations
How do open-market operations affect the money supply?
In a particular economy, currency held by the public is 1,000 shekels, bank reserves are 200 shekels, and the desired reserve-deposit ratio is 0.2. What is the money supply? How is the money supply affected if the central bank prints 100 shekels and uses this new currency to buy government bonds from the public? Assume that the public does not wish to change the amount of currency it holds.
As bank reserves are 200 shekels and the reserve-deposit ratio is 0.2, bank deposits must equal 200 shekels/0.2, or 1,000 shekels. The money supply, equal to the sum of currency held by the public and bank deposits, is therefore 2,000 shekels, a result you can confirm using Equation 22.2.
The open-market purchase puts 100 more shekels into the hands of the public. We assume that the public continues to want to hold 1,000 shekels in currency, so they will deposit the additional 100 shekels in the commercial banking system, raising bank reserves from 200 to 300 shekels. As the desired reserve-deposit ratio is 0.2, multiple rounds of lending and redeposit will eventually raise the level of bank deposits to 300 shekels/0.2, or 1,500 shekels. The money supply, equal to 1,000 shekels held by the public plus bank deposits of 1,500 shekels, equals 2,500 shekels. So the open-market purchase of 100 shekels, by raising bank reserves by 100 shekels, has increased the money supply by 500 shekels. Again, you can confirm this result using Equation 22.2.
CONCEPT CHECK 22.3
Continuing Example 22.3, suppose that instead of an open-market purchase of 100 shekels the central bank conducts an open-market sale of 50 shekels’ worth of government bonds. What happens to bank reserves, bank deposits, and the money supply?
THE FED’S ROLE IN STABILIZING FINANCIAL MARKETS: BANKING PANICS
Besides controlling the money supply, the Fed also has the responsibility (together with other government agencies) of ensuring that financial markets operate smoothly. Indeed, the creation of the Fed in 1913 was prompted by a series of financial market crises that disrupted both the markets themselves and the U.S. economy as a whole. The hope of the Congress was that the Fed would be able to eliminate or at least control such crises.
Historically, in the United States, banking panics were perhaps the most disruptive type of recurrent financial crisis. In a banking panic, news or rumors of the imminent bankruptcy of one or more banks leads bank depositors to rush to withdraw their funds. Next, we will discuss banking panics and the Fed’s attempts to control them.
Why do banking panics occur? An important factor that helps make banking panics possible is the existence of fractional-reserve banking. In a fractional-reserve banking system, like that of the United States and all other industrialized countries, bank reserves are less than deposits, which means that banks do not keep enough cash on hand to pay off their depositors if they were all to decide to withdraw their deposits. Normally this is not a problem, as only a small percentage of depositors attempt to withdraw their funds on any given day. But if a rumor circulates that one or more banks are in financial trouble and may go bankrupt, depositors may panic, lining up to demand their money. Since bank reserves are less than deposits, a sufficiently severe panic could lead even financially healthy banks to run out of cash, forcing them into bankruptcy and closure.
The Federal Reserve was established in response to a particularly severe banking panic that occurred in 1907. The Fed was equipped with two principal tools to try to prevent or moderate banking panics. First, the Fed was given the power to supervise and regulate banks. It was hoped that the public would have greater confidence in banks, and thus be less prone to panic, if people knew that the Fed was keeping a close watch on bankers’ activities. Second, the Fed was allowed to make direct loans to banks through a new facility called the discount window, which we will discuss in a later chapter. The idea was that, during a panic, banks could borrow cash from the Fed with which to pay off depositors, avoiding the need to close.
No banking panics occurred between 1914, when the Fed was established, and 1930. However, between 1930 and 1933 the United States experienced the worst and most protracted series of banking panics in its history. Economic historians agree that much of the blame for this panic should be placed on the Fed, which neither appreciated the severity of the problem nor acted aggressively enough to contain it.
The Economic Naturalist 22.2
Why did the banking panics of 1930–1933 reduce the national money supply?
The worst banking panics ever experienced in the United States occurred during the early stages of the Great Depression, between 1930 and 1933. During this period, approximately one-third of the banks in the United States were forced to close. This near-collapse of the banking system was probably an important reason that the Depression was so severe. With many fewer banks in operation, it was very difficult for small businesses and consumers during the early 1930s to obtain credit. Another important effect of the banking panics was to greatly reduce the nation’s money supply. Why should banking panics reduce the national money supply?
During a banking panic, people are afraid to keep deposits in a bank because of the risk that the bank will go bankrupt and their money will be lost (this was prior to the introduction of federal deposit insurance, discussed below). During the 1930–1933 period, many bank depositors withdrew their money from banks, holding currency instead. These withdrawals reduced bank reserves. Each extra dollar of currency held by the public adds $1 to the money supply; but each extra dollar of bank reserves translates into several dollars of money supply because in a fractional-reserve banking system, each dollar of reserves can “support” several dollars in bank deposits. Thus the public’s withdrawals from banks, which increased currency holdings by the public but reduced bank reserves by an equal amount, led to a net decrease in the total money supply (currency plus deposits).
In addition, fearing banking panics and the associated withdrawals by depositors, banks increased their reserve-deposit ratios, which reduced the quantity of deposits that could be supported by any given level of bank reserves. This change in reserve-deposit ratios also tended to reduce the money supply.
Data on currency holdings by the public, the reserve-deposit ratio, bank reserves, and the money supply for selected dates are shown in Table 22.7. Notice the increase over the period in the amount of currency held by the public and in the reserve-deposit ratio, as well as the decline in bank reserves after 1930. The last column shows that the U.S. money supply dropped by about one-third between December 1929 and December 1933.
Using Equation 22.2, we can see that increases in currency holdings by the public and increases in the reserve-deposit ratio both tend to reduce the money supply. These effects were so powerful in 1930–1933 that the nation’s money supply, shown in the fourth column of Table 22.7, dropped precipitously, even though currency holdings and bank reserves, taken separately, actually rose during the period.
CONCEPT CHECK 22.4
Using the data from Table 22.7, confirm that the relationship between the money supply and its determinants is consistent with Equation 22.2. Would the money supply have fallen in 1931–1933 if the public had stopped withdrawing deposits after December 1930 so that currency held by the public had remained at its December 1930 level?
CONCEPT CHECK 22.5
According to Table 22.7, the U.S. money supply fell from $44.1 billion to $37.3 billion over the course of 1931. The Fed did use open-market purchases during 1931 to replenish bank reserves in the face of depositor withdrawals. Find (a) the quantity of reserves that the Fed injected into the economy in 1931 and (b) the quantity of reserves the Fed would have had to add to the economy to keep the money supply unchanged from 1930, assuming that public currency holdings and reserve-deposit ratios for each year remained as reported in the table. Why has the Fed been criticized for being too timid in 1931?
When the Fed failed to stop the banking panics of the 1930s, policymakers decided to look at other strategies for controlling panics. In 1934 Congress instituted a system of deposit insurance. Under a system of deposit insurance, the government guarantees depositors—specifically, under current rules, those with deposits of less than $250,000—that they will get their money back even if the bank goes bankrupt. Deposit insurance eliminates the incentive for people to withdraw their deposits when rumors circulate that the bank is in financial trouble, which nips panics in the bud. Indeed, since deposit insurance was instituted, the United States has had no significant banking panics.
Unfortunately, deposit insurance is not a perfect solution to the problem of banking panics. An important drawback is that when deposit insurance is in force, depositors know they are protected no matter what happens to their bank, and they become completely unconcerned about whether their bank is making prudent loans. This situation can lead to reckless behavior by banks or other insured intermediaries. For example, during the 1980s many savings and loan associations in the United States went bankrupt, in part because of reckless lending and financial investments. Like banks, savings and loans have deposit insurance, so the U.S. government had to pay savings and loan depositors the full value of their deposits. This action ultimately cost U.S. taxpayers hundreds of billions of dollars.
RECAP
THE FEDERAL RESERVE SYSTEM
· The Fed is the central bank of the United States. Like central banks in other countries, it has two main responsibilities. First, it is in charge of monetary policy—that is, it determines how much money circulates in the economy. Second, it bears important responsibility for the oversight and regulation of financial markets. The Fed also plays a major role during periods of crisis in financial markets.
· An open-market purchase is the purchase of government bonds from the public by the Fed for the purpose of increasing the supply of bank reserves and the money supply. An open-market sale is the sale by the Fed of government bonds to the public for the purpose of reducing bank reserves and the money supply.
· Historically, such open-market operations are the most important among several ways that the Fed has of affecting the supply of bank reserves and the money supply.
MONEY AND PRICES
From a macroeconomic perspective, a major reason that control of the supply of money is important is that, in the long run, the amount of money circulating in an economy and the general level of prices are closely linked. Indeed, it is virtually unheard of for a country to experience high, sustained inflation without a comparably rapid growth in the amount of money held by its citizens. The late economist Milton Friedman summarized the inflation–money relationship by saying, “Inflation is always and everywhere a monetary phenomenon.” We will see in a later chapter that, over short periods, inflation can arise from sources other than an increase in the supply of money. But over a longer period, and particularly for more severe inflations, Friedman’s dictum is certainly correct: The rate of inflation and the rate of growth of the money supply are closely related.
The existence of a close link between money supply and prices should make intuitive sense. Imagine a situation in which the available supply of goods and services is approximately fixed. Then the more cash (say, dollars) that people hold, the more they will be able to bid up the prices of the fixed supply of goods and services. Thus, a large money supply relative to the supply of goods and services (too much money chasing too few goods) tends to result in high prices. Likewise, a rapidly growing supply of money will lead to quickly rising prices—that is, inflation.
VELOCITY
To explore the relationship of money growth and inflation in a bit more detail, it is useful to introduce the concept of velocity. In economics, velocity is a measure of the speed at which money circulates, that is, the speed at which money changes hands in transactions involving final goods and services. For example, a given dollar bill might pass from your hand to the grocer’s when you buy a quart of milk. The same dollar may then pass from the grocer to a new car dealer when your grocer buys a car, and then from the car dealer to her doctor in exchange for medical services. The more quickly money circulates from one person to the next, the higher its velocity. More formally, velocity is defined as the value of transactions completed in a period of time divided by the stock of money required to make those transactions. The higher this ratio, the faster the “typical” dollar is circulating.
As a practical matter, we usually do not have precise measures of the total value of transactions taking place in an economy; so, as an approximation, economists often measure the total value of transactions in a given period by nominal GDP for that period. A numerical value of velocity can be obtained from the following formula:
Let V stand for velocity and let M stand for the particular money stock being considered (for example, M1 or M2). Nominal GDP (a measure of the total value of transactions) equals the price level P times real GDP (Y). Using this notation, we can write the definition of velocity as
(22.3)
The higher the V, the faster money is circulating.
EXAMPLE 22.4The Velocity of Money in the U.S. Economy
What is the velocity of the U.S. money supply?
In 2016, M1 was $3,247.9 billion, M2 was $12,829.2 billion, and nominal GDP was $18,624.5 billion. We can use these data along with Equation 22.3 to find velocity for both definitions of the money supply. For M1, we have
Similarly, velocity for M2 was
You can see that the velocity of M1 is higher than that of M2. This makes sense: Because the components of M1, such as cash and checking accounts, are used more frequently for transactions, each dollar of M1 “turns over” more often than the average dollar of M2.
A variety of factors determine velocity. A leading example is advances in payment technologies such as the introduction of credit cards and debit cards or the creation of networks of automated teller machines (ATMs). These technologies and payment methods have allowed people to carry out their daily business while holding less cash, and thus have tended to increase velocity over time. Other examples include economic conditions and monetary policy, which could increase or decrease velocity more quickly. As we will discuss in Chapter 26, Stabilizing the Economy: The Role of the Fed, velocity for M1 increased from less than 4 in 1960 to more than 10 in 2007, before declining again to less than 6 more recently.
MONEY AND INFLATION IN THE LONG RUN
We can use the definition of velocity to see how money and prices are related in the long run. First, rewrite the definition of velocity, Equation 22.3, by multiplying both sides of the equation by the money stock M. This yields
M × V = P × Y.(22.4)
Equation 22.4 is called the quantity equation. The quantity equation states that money times velocity equals nominal GDP. Because the quantity equation is simply a rewriting of the definition of velocity, Equation 22.3, it always holds exactly.
The quantity equation is historically important because late nineteenth- and early twentieth-century monetary economists, such as Yale’s Irving Fisher, used this relationship to theorize about the relationship between money and prices. We can do the same thing here. To keep things simple, imagine that velocity V is determined by current payment technologies and thus is approximately constant over the period we are considering. Likewise, suppose that real output Y is approximately constant. If we use a bar over a variable to indicate that the variable is constant, we can rewrite the quantity equation as
(22.5)
where we are treating 
and 
as fixed numbers.
Now look at Equation 22.5 and imagine that for some reason the Federal Reserve increases the money supply M by 10 percent. Because and are assumed to be fixed, Equation 22.5 can continue to hold only if the price level P also rises by 10 percent. That is, according to the quantity equation, a 10 percent increase in the money supply M should cause a 10 percent increase in the price level P, that is, an inflation of 10 percent.
The intuition behind this conclusion is the one we mentioned at the beginning of this section. If the quantity of goods and services Y is approximately constant (and assuming that velocity V also is constant), an increase in the supply of money will lead people to bid up the prices of the available goods and services. Thus, high rates of money growth will tend to be associated with high rates of inflation. Figure 22.1 shows this relationship for 10 countries in Latin America during the period 1995–2001. You can see that countries with higher rates of money growth tend also to have higher rates of inflation. The relationship between money growth and inflation is not exact, in part because—as we mentioned earlier, and contrary to the simplifying assumption we made here—velocity and output are not constant but vary over time.
FIGURE 22.1 Inflation and Money Growth in Latin America, 1995–2001.Latin American countries with higher rates of growth in their money supplies also tended to have higher rates of inflation between 1995 and 2001. (The data for Argentina and Uruguay end on 2000 and the data for Ecuador end in 1997. In 1997 Ecuador abandoned its currency, the sucre, and began using dollars instead.)
If high rates of money growth lead to inflation, why do countries allow their money supplies to rise quickly? Usually, rapid rates of money growth are the result of large government budget deficits. Particularly in developing countries or countries suffering from war or political instability, governments sometimes find that they cannot raise sufficient taxes or borrow enough from the public to cover their expenditures. In this situation, the government’s only recourse may be to print new money and use this money to pay its bills. If the resulting increase in the amount of money in circulation is large enough, the result will be inflation.
A very large budget deficit that is financed by printing money can lead to hyperinflation, which we discussed in Chapter 18, Measuring the Price Level and Inflation. The Confederate States of America during the Civil War, Germany after World War I, and, more recently, Zimbabwe and Venezuela, found themselves in exactly this situation: They could not raise sufficient taxes to cover government spending, so they printed large quantities of paper money to pay for government expenditures. As Equation 22.5 predicts, the initial large increase in M led to a large increase in P. But this made the deficit still larger in nominal terms, leading in turn to a larger increase in M in order to finance that larger nominal deficit. This in turn led to an even larger increase in P, and so on, with both M and P growing at an accelerating rate.
Equation 22.5 also provides a way to stop hyperinflations: reduce the growth rate of the money supply. This is, of course, easier said than done. To accomplish this, the government must somehow cut spending and/or raise taxes so that the budget deficit is smaller and can be financed through borrowing rather than money issue. The German government, for example, enacted reforms in late 1923 that made it difficult for the government to print money to cover its budget deficits. Inflation slowed dramatically in the months after the reform. The Confederacy, on the other hand, was unable to stop its hyperinflation. After the battles of Gettysburg and Vicksburg in 1863, it was clear that the Confederacy would ultimately lose the war. It could only sell bonds at exorbitant interest rates and could not collect taxes since the individual states controlled tax collections. Hyperinflation ended only with the Confederacy’s defeat in April 1865.
As mentioned in Chapter 18, Measuring the Price Level and Inflation, episodes of hyperinflation rarely last for long. It is not rare for them to end with a fall of the government.
RECAP
THE MONEY SUPPLY AND PRICES
· A high rate of money growth generally leads to inflation. The larger the amount of money in circulation, the higher the public will bid up the prices of available goods and services.
· Velocity measures the speed at which money circulates, that is, the speed at which money changes hands in transactions involving final goods and services; equivalently it is equal to nominal GDP divided by the stock of money. A numerical value for velocity can be obtained from the equation V = (P × Y)/M, where V is velocity, P × Y is nominal GDP, and M is the money supply.
· The quantity equation states that money times velocity equals nominal GDP, or, in symbols, M × V = P × Y. The quantity equation is a restatement of the definition of velocity and thus always holds. If velocity and output are approximately constant, the quantity equation implies that a given percentage increase in the money supply leads to the same percentage increase in the price level. In other words, the rate of growth of the money supply equals the rate of inflation.
SUMMARY
· Money is any asset that can be used in making purchases, such as currency and checking account balances. Money has three main functions: It is a medium of exchange, which means that it can be used in transactions. It is a unit of account, in that economic values are typically measured in units of money (for example, dollars). And it is a store of value, a means by which people can hold wealth. In practice, it is difficult to measure the money supply since many assets have some moneylike features. A relatively narrow measure of money is M1, which includes currency and checking accounts. A broader measure of money, M2, includes all the assets in M1 plus additional assets that are somewhat less convenient to use in transactions than those included in M1. (LO1)
· Because bank deposits are part of the money supply, the behavior of commercial banks and of bank depositors affects the amount of money in the economy. A key factor is the reserve-deposit ratio chosen by banks. Bank reserves are cash or similar assets held by commercial banks, for the purpose of meeting depositor withdrawals and payments. The reserve-deposit ratio is bank reserves divided by deposits in banks. A banking system in which all deposits are held as reserves practices 100 percent reserve banking. Modern banking systems have reserve-deposit ratios less than 100 percent and are called fractional-reserve banking systems. (LO2)
· Commercial banks create money through multiple rounds of lending and accepting deposits. This process of lending and increasing deposits comes to an end when banks’ reserve-deposit ratios equal their desired levels. At that point, bank deposits equal bank reserves divided by the desired reserve-deposit ratio. The money supply equals currency held by the public plus deposits in the banking system. (LO2)
· The central bank of the United States is called the Federal Reserve System, or the Fed for short. The Fed’s two main responsibilities are making monetary policy, which means determining how much money will circulate in the economy, and overseeing and regulating financial markets, especially banks. Created in 1914, the Fed is headed by a Board of Governors made up of seven governors appointed by the president. One of these seven governors is appointed chair. The Federal Open Market Committee, which meets about eight times a year to determine monetary policy, is made up of the seven governors, the president of the Federal Reserve Bank of New York, and four of the presidents of the regional Federal Reserve banks. (LO3)
· One of the original purposes of the Federal Reserve was to help eliminate or control banking panics. A banking panic is an episode in which depositors, spurred by news or rumors of the imminent bankruptcy of one or more banks, rush to withdraw their deposits from the banking system. Because banks do not keep enough reserves on hand to pay off all depositors, even a financially healthy bank can run out of cash during a panic and be forced to close. The Federal Reserve failed to contain banking panics during the Great Depression, which led to sharp declines in the money supply. The adoption of a system of deposit insurance in the United States eliminated banking panics. A disadvantage of deposit insurance is that if banks or other insured intermediaries make bad loans or financial investments, the taxpayers may be responsible for covering the losses. (LO3)
· In the long run, the rate of growth of the money supply and the rate of inflation are closely linked because a larger amount of money in circulation allows people to bid up the prices of existing goods and services. Velocity measures the speed at which money circulates; equivalently, it is the value of transactions completed in a period of time, divided by the stock of money required to make those transactions. Velocity is defined by the equation V = (P × Y)/M, where V is velocity, P × Y is nominal GDP (a measure of the total value of transactions), and M is the money supply. The definition of velocity can be rewritten as the quantity equation, M × V = P × Y. The quantity equation shows that, if velocity and output are constant, a given percentage increase in the money supply will lead to the same percentage increase in the price level. (LO4)
KEY TERMS
bank reserves
banking panic
barter
Board of Governors
deposit insurance
Federal Open Market Committee (FOMC)
Federal Reserve System (the Fed)
fractional-reserve banking system
M1
M2
medium of exchange
money
monetary policy
100 percent reserve banking
open-market operations
open-market purchase
open-market sale
quantity equation
reserve-deposit ratio
store of value
unit of account
velocity
REVIEW QUESTIONS
1. What is money? Why do people hold money even though it pays a lower return than other financial assets? (LO1)
2. Suppose that the public switches from doing most of its shopping with currency to using checks instead. If the Fed takes no action, what will happen to the national money supply? Explain. (LO2, LO3)
3. The Fed wants to reduce the U.S. money supply using open-market operations. Describe what it would do and explain how this action would accomplish the Fed’s objective. (LO3)
4. What is a banking panic? Prior to the introduction of deposit insurance, why might even a bank that had made sound loans have reason to fear a panic? (LO3)
5. Define velocity. How has the introduction of new payment technologies affected velocity? Explain. (LO4)
6. Use the quantity equation to explain why money growth and inflation tend to be closely linked. (LO4)
PROBLEMS
1. During World War II, an Allied soldier named Robert Radford spent several years in a large German prisoner- of-war camp. At times, more than 50,000 prisoners were held in the camp, with some freedom to move about within the compound. Radford later wrote an account of his experiences. He described how an economy developed in the camp, in which prisoners traded food, clothing, and other items. Services, such as barbering, were also exchanged. Lacking paper money, the prisoners began to use cigarettes (provided monthly by the Red Cross) as money. Prices were quoted, and payments made, using cigarettes. (LO1)
a. In Radford’s POW camp, how did cigarettes fulfill the three functions of money?
b. Why do you think the prisoners used cigarettes as money, as opposed to other items of value such as squares of chocolate or pairs of boots?
c. Do you think a nonsmoking prisoner would have been willing to accept cigarettes in exchange for a good or service in Radford’s camp? Why or why not?
2. Redo the example of Gorgonzola in the text (see Tables 22.2 to 22.6), assuming that (1) initially, the Gorgonzolan central bank puts 5,000,000 guilders into circulation, and (2) commercial banks desire to hold reserves of 20 percent of deposits. As in the text, assume that the public holds no currency. Show the consolidated balance sheets of Gorgonzolan commercial banks for each of the following instances. (LO2)
a. After the initial deposits (compare to Table 22.2).
b. After one round of loans (compare to Table 22.3).
c. After the first redeposit of guilders (compare to Table 22.4).
d. After two rounds of loans and redeposits (Table 22.5).
e. What are the final values of bank reserves, loans, deposits, and the money supply (compare to Table 22.6)?
3. Answer each of the following questions: (LO2)
a. Bank reserves are 100, the public holds 200 in currency, and the desired reserve-deposit ratio is 0.25. Find deposits and the money supply.
b. The money supply is 500, and currency held by the public equals bank reserves. The desired reserve-deposit ratio is 0.25. Find currency held by the public and bank reserves.
c. The money supply is 1,250, of which 250 is currency held by the public. Bank reserves are 100. Find the desired reserve-deposit ratio.
4. When a central bank increases bank reserves by $1, the money supply rises by more than $1. The amount of extra money created when the central bank increases bank reserves by $1 is called the money multiplier. (LO2)
a. Explain why the money multiplier is generally greater than 1. In what special case would it equal 1?
b. The initial money supply is $1,000, of which $500 is currency held by the public. The desired reserve-deposit ratio is 0.2. Find the increase in money supply associated with increases in bank reserves of $1, $5, and $10. What is the money multiplier in this economy?
c. Find a general rule for calculating the money multiplier.
5. Refer to Table 22.7. Suppose that the Fed had decided to set the U.S. money supply in December 1932 and in December 1933 at the same value as in December 1930. Assuming that the values of currency held by the public and the reserve-deposit ratio had remained as given in the table, by how much more should the Fed have increased bank reserves at each of those dates to accomplish that objective? (LO3)
6. The Federal Reserve System was created by the Federal Reserve Act, passed by Congress in 1913, and began operations in 1914. Like all central banks, the Fed is a government agency. Which of the following statements about the Fed is false? (LO3)
a. The Fed has the power to supervise and regulate banks.
b. The Fed’s goals are to promote economic growth, maintain low inflation, and watch over a smooth operation of financial markets.
c. The Fed is the “lender of last resort.”
d. The Fed is allowed to make a profit like commercial banks.
7. Consider a country in which real GDP is $8 trillion, nominal GDP is $10 trillion, M1 is $2 trillion, and M2 is $5 trillion. (LO4)
a. Find velocity for M1 and for M2.
b. Show that the quantity equation holds for both M1 and M2.
8. Consider the following hypothetical data for 2016 and 2017: (LO4)
a. Find the price level for 2016 and 2017. What is the rate of inflation between the two years?
b. What is the rate of inflation between 2016 and 2017 if the money supply in 2017 is 1,100 instead of 1,050?
c. What is the rate of inflation between 2016 and 2017 if the money supply in 2017 is 1,100 and output in 2017 is 12,600?
ANSWERS TO CONCEPT CHECKS
22.1Table 22.5 shows the balance sheet of banks after two rounds of lending and redeposits. At that point, deposits are 2,710,000 guilders and reserves are 1,000,000 guilders. Since banks have a desired reserve-deposit ratio of 10 percent, they will keep 271,000 guilders (10 percent of deposits) as reserves and lend out the remaining 729,000 guilders. Loans to farmers are now 2,439,000 guilders. Eventually the 729,000 guilders lent to the farmers will be redeposited into the banks, giving the banks deposits of 3,439,000 guilders and reserves of 1,000,000 guilders. The balance sheet is as shown in the accompanying table:
Notice that assets equal liabilities. The money supply equals deposits, or 3,439,000 guilders. Currency held in the banks as reserves does not count in the money supply. (LO2)
22.2Because the public holds no currency, the money supply equals bank deposits, which in turn equal bank reserves divided by the reserve-deposit ratio (Equation 22.1). If bank reserves are 1,000,000 and the reserve-deposit ratio is 0.05, then deposits equal 1,000,000/0.05 = 20,000,000 guilders, which is also the money supply. If bank reserves are 2,000,000 guilders and the reserve-deposit ratio is 0.10, then the money supply and deposits are again equal to 20,000,000 guilders, or 2,000,000/0.10. (LO2)
22.3If the central bank sells 50 shekels of government bonds in exchange for currency, the immediate effect is to reduce the amount of currency in the hands of the public by 50 shekels. To restore their currency holding to the desired level of 1,000 shekels, the public will withdraw 50 shekels from commercial banks, reducing bank reserves from 200 shekels to 150 shekels. The desired reserve-deposit ratio is 0.2, so ultimately deposits must equal 150 shekels in reserves divided by 0.2, or 750 shekels. (Note: To contract deposits, the commercial banks will have to “call in” loans, reducing their loans outstanding.) The money supply equals 1,000 shekels in currency held by the public plus 750 shekels in deposits, or 1,750 shekels. Thus the open-market purchase has reduced the money supply from 2,000 to 1,750 shekels. (LO3)
22.4Verify directly for each date in Table 22.7 that
Money supply =
For example, for December 1929 we can check that 45.9 = 3.85 + 3.15/0.075.
Suppose that the currency held by the public in December 1933 had been 3.79, as in December 1930, rather than 4.85, and that the difference (4.85 − 3.79 = 1.06) had been left in the banks. Then bank reserves in December 1933 would have been 3.45 + 1.06 = 4.51, and the money supply would have been 3.79 + 4.51/0.133 = 37.7. So the money supply would still have fallen between 1930 and 1933 if people had not increased their holdings of currency, but only by about half as much. (LO3)
22.5Over the course of 1931, currency holdings by the public rose by $0.80 billion but bank reserves fell overall by only $0.20 billion. Thus the Fed must have replaced $0.60 billion of lost reserves during the year through open-market purchases or discount window lending.
Currency holdings at the end of 1931 were $4.59 billion. To have kept the money supply at the December 1930 value of $44.1 billion, the Fed would have had to ensure that bank deposits equaled $44.1 billion − $4.59 billion, or $39.51 billion. As the reserve-deposit ratio in 1931 was 0.095, this would have required bank reserves of 0.095 × $39.51 billion, or $3.75 billion, compared to the actual value in December 1931 of $3.11 billion. Thus, to keep the money supply from falling, the Fed would have had to increase bank reserves by $0.64 billion more than it did. The Fed has been criticized for increasing bank reserves by only about half what was needed to keep the money supply from falling. (LO3)
1Barbara A. Good, “Private Money: Everything Old Is New Again,” Federal Reserve Bank of Cleveland, Economic Commentary, April 1, 1998.