we just understood the equilibrium and transmission mechanisms of the goods market. now we will...

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:

http://upload.wikimedia.org/wikipedia/commons/0/0d/One_US_dollar_note_0127_22.jpg

- 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


Deposits( $5)

Deposits

PANEL 2Commercial BanksFederal Reserve

LiabilitiesAssetsLiabilitiesAssets

$95$15Reserves( $5)

Reserves( $5)

$15$95Securities( $5)

$80LoansCurrency$80



$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)


$5

$0

Liabilities

$5

$0

Debts$5

Liabilities

$80

Net Worth

Debts

Currency

Net Worth

Securities(+ $5)

Deposits( $5)


Deposits


Deposits( $5)

Deposits

PANEL 2Commercial BanksFederal Reserve


$95$15Reserves( $5)

Reserves( $5)

$15$95Securities( $5)

$80LoansCurrency$80



$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


Deposits$800$100ReservesReserves$100$200Government

(+ $300)$700Loans(+ $300)

Currency$100securities



$400LoansCurrency$100securities




PANEL 1: REQUIRED RESERVE RATIO = 20%

PANEL 2: REQUIRED RESERVE RATIO = 12.5%




(+ $300)$700Loans(+ $300)

Currency$100securities



$400LoansCurrency$100securities




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



Deposits(+ $100)

$500$100Reserves(+ $20)

Reserves(+ $20)

$100$160Securities

Amount owed to Fed (+ $20)

$20$420Loans(+ $100)

Currency$80$20Loans



$320LoansCurrency$80

Deposits$400$80ReservesReserves$80$160Securities



PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED

PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED



Deposits(+ $100)

$500$100Reserves(+ $20)

Reserves(+ $20)

$100$160Securities

Amount owed to Fed (+ $20)

$20$420Loans(+ $100)

Currency$80$20Loans



$320LoansCurrency$80

Deposits$400$80ReservesReserves$80$160Securities



PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED

• Supply curve of money

we just understood the equilibrium and transmission mechanisms of the goods market. now we will...

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