Lecture Notes for Chapter 6 of
MACROECONOMICS:
An Introduction

4/27/99

• What money is.
• What money does.
• What kinds there are.
• How much there is.
• How it is created.
• What the Federal Reserve is.
• How the Fed controls money.

• That which is accepted in payment
• for goods & services
• to settle debts.
• It is an asset, a special kind of asset
• Examples:
• a $20 dollar bill,
• a personal check.

• Income: "the average programmer makes $150,000 per year."
• Wealth: "Bill Gates is worth $90 billion."
• Debt: "US government owes $5 trillion"
• These are examples of using money as a measuring stick, a unit of account.

• Currency, dollar bills and coins, and
  
• the balance in your checking account.

• Money avoids the costly and time consuming process of barter.
• Money is a fundamental invention like the wheel.
• No doubt in use on other planets!
• The oil that lubricates the wheels of commerce.

• Gives us a yardstick of value.
• Allows comparison of the costs and values of very different things,
  say the cost of a CD and theater ticket.
• We can compare incomes in dollars.
• Not so easy in a barter economy!

• A reserve of purchasing power.
• The most liquid of all assets.
• How does inflation affect this use?
• Steady predictable inflation?
• Highly variable inflation?

• A house is valuable but not liquid.
• GE stock can be turned into cash in a few days, but value is uncertain.
• A T bond is very liquid; and
  price fluctuates less than a stock.
• A T bill is very, very liquid; quickly converted to cash, very stable in price.

• On the balance sheets of firms
• "this mutual fund has 40% in cash"
• "cash" means T bills or similar.
• But a T bill is not money! Why?

• A $100 bill is more liquid than a T bill,
• but not as liquid as a $20 bill.
• Try giving a cab driver a $100 bill at
  1 am in New York City.
• The U.S. $20 is surely the most liquid of all assets on earth.
• It is also the most counterfeited!

• Has intrinsic value.
• Examples:
• metals such as copper,
• silver and
• gold
• cigarettes (in prisoner-of-war camps)
• cattle.

• Durability.
• Valuable in small sizes and weights.
• Divisible into varying sizes.
• Easily verified as genuine.
• Stable in value.
• Gold does very well on all five points.
• Almost all the gold that people have ever used is still in use!

• Stamped by the government
• Standardized weight
• Immediately recognized value.
• Earliest minted by the Greeks ~ 600BC.
• But governments often cheated,
  diluting the gold content with cheaper metal
• Old, valuable coins quickly disappeared.

• Sandwich coins introduced in 1960’s,
  silver coins soon disappeared.
• Illegal to sell them, but many did.
• Coins minted today are token coins,
  metals they contain have little value.

• Invented in China,
  to Europe with Marco Polo ~1200.
• Claim on gold or silver
  from government or a bank.
• All paper money and coins today are . .

• Of value only because it is legal tender.
• Law says seller must accept it
  in payment for goods and services,
• & lenders in payment of debt.
• We accept it since know others will.
• All the paper money and coins
  in the world today are fiat money!
• Paper money and coins as currency.

• Checks.
• Personal checks are not legal tender
• and are not as liquid as currency.
• Money market mutual fund checks
• Savings account transfers by phone.
• Savings accounts & other very liquid but not checkable are near money.

• Means: "What is the total of currency, checkable deposits, and savings accounts?"
• Does not mean:
  "What is the total of all assets?"
  "What is total income?"
• "Money" here means medium of exchange, not a yardstick of value.

• Currency: $ 380 billion
• plus checkable deposits = M1: $1,117b
• plus MMMF and savings = M2: $3,749b

• Where is it all??
• Much is used in other countries,
• perhaps 40%.
• Often where local currency is unstable
• Argentina uses U.S. currency officially to stabilize their monetary system
• In illegal businesses, tax avoidance

• Japanese carry more currency (Yen) than Americans do (dollars). Why?
• A credit card or "plastic money" is not really money but a short term loan.
• Credit cards have not replaced money
• Will cards ever replace money?

• Banks are as old as civilization itself.
• In Middle Ages "usury" was banned.
• Banking revived in Italy during the Renaissance; "banco" means bench.
• The Medici family established their bank in Florence in the 1300's and accumulated great wealth and power, making Florence a center of the arts.

• Goldsmith had a vault for keeping valuables, so offered safekeeping.
• Gold and silver coins worth say £100 deposited, receipts or "notes" given.
• Notes only occasionally redeemed.
• Goldsmith's reserves, the coins in the vault, were equal to deposits, £100.
• why not lend out notes, say £200?

• Goldsmith has created £200 from thin air
• That is fractional reserve banking.
• As long as borrowers continued to make payment on their loans, all was well.
• If loans were not repaid, the bank could not redeem its notes, and the bank failed.
• A bank holds illiquid assets (loans) while issuing liquid liabilities (notes).

• The bank would fail if holders of its notes all demanded their coins at once.
• A "run" on the bank has always been a threat to any fractional reserve bank.
• Bank runs were common in 1800s,
• during the Great Depression of the 30s thousands of banks failed in the U. S.

• The Coinage Act of 1792 established the dollar as the monetary unit for the US.
• amount of silver or gold in coins fixed.
• From 1834 to 1933 gold was $20.67/oz
• Except for Civil War "greenbacks", paper money was issued by banks.
• Bank reserves were silver and gold

• 1836 to 1864 new banks on frontier.
• notes of hundreds of banks circulated, all claiming to be "good as gold."
• bank's notes promised to pay in silver or gold, but exceeded banks' reserves.
• Magic of fractional reserve banking!

• Gold was the more important of the two monetary metals and the system became known as the gold standard.
• That did not mean that all the money was backed by gold,
• but it did tie the quantity of money to the relatively fixed supply of gold.

• Reserves include currency in the vault and deposits at the Federal Reserve.
• The remaining $900 has been lent out.
• Bank earns interest on loans
• pays interest on some deposits and
• provides services such as drive through
• and make a profit for shareholders.

• 19th century Americans viewed central bank as excessive concentration of power.
• Two early central banks were disbanded.
• The Bank of England, originally a private bank, was model for modern central banks.
• Our "Fed" was created in 1913 to stabilize the monetary system, be a bank’s bank.

• Ironically, the worst bank failures occurred in 1929 under Fed supervision.
• One factor: 12 district banks decentralized authority, which lead to inaction.
• Fed was reorganized in 1930s,
• control centralized in Wash DC under the
  Board of Governors
• as critics feared!

• The "monetary authority"
• empowered to issue U.S. currency.
• 7 Governors are appointed by the President, confirmed by the Senate,
• serve for 14 years.
• Chairman is a governor appointed by the President to 4 year term.

• Federal Open Market Committee
• It meets 8 times a year
• Meetings are secret
• Members: all 7 governors
  plus 5 district bank presidents.
• President of the NY Fed always votes,
  represents NYC as center of finance.

• Presides over meetings of the FOMC, a source of considerable power.
• Now Alan Greenspan.
• Succeeded Paul Volcker in 1986 who had been appointed by Pres. Carter.
• Greenspan was reappointed in 1996.

• Fed building looks like a Roman temple
• Greenspan’s office is the inner sanctum
• Secrecy of its inner workings has always been a source of it power
• Recently more open due to pressure from Congress.
• FOMC now announces decisions immediately after meeting

• achieve long term growth,
• a high level of employment, and
• reasonable price stability.
• This is "Monetary Policy"

• Bank mergers,
• the soundness of banks,
• consumer protection,
• the scope of banks’ activities.
• When a bank gets into trouble, the Fed usually arranges a "shotgun marriage" with a stronger bank.

• In event of national crisis or bank failure.
• Fed failed to do this in Great Depression!
• Bank failures made the Depression worse.
• Since the Fed employs 247 economists, it is also known as "the employer of last resort."

• FDIC founded in response to the 1930s
• to protect depositors and
• stabilize the banking system
• FSLIC did the same for Savings and Loans
• Both created a "moral hazard"
• a weak bank or S&L could attract deposits on the guarantee of the U.S.
• FSLIC was devoured by Texas S&Ls

• Allowed S&Ls to do what banks do
• Raised their insurance limits, a disaster
• Extended Fed control
• Garn-St.Germain Act of 1982 erased distinctions between banks and S&Ls
• Banking was a "3-6-3" business: pay 3%, loan at 6%, on the golf course by 3pm!
• Now it is highly competitive.

• Through open market operations
  it can add or drain bank reserves.
• Fed buys or sells Treasury securities.
• Pays with money it creates by fiat.
• Boosted by "Money multiplication."

• Banks hold some reserves.
• Required as a fraction of deposits
• Excess reserves kept to a minimum
• A bank that is short of reserves can
• go to the "discount window" and borrow at the "discount rate" or
• borrow from other banks in "fed funds market" at the "fed funds rate."

• Fed prints up bills worth $1,000,
  buys a T bill for $1000 from someone.
• How can it do that?
• It has the authority to print money!
• Seller deposits the $1000 in their bank.
• That bank now has $1000 in new deposits.
• If the reserve requirement is 10%, it now has excess reserves of $900.

• Joe remodels his house, the contractor puts the $900 in his bank account.
• Now that bank has $900 in new deposits and $810 in excess reserves.
• This process continues until the $1,000 of new reserves is completely used up as reserves supporting new deposits:

• use a spreadsheet on the computer
• use of the result from college algebra that for any fraction x,
• 1+x+x²+x³+ ... = 1/(1-x)
• At each stage, the next quantity is .90 of the previous quantity

• = $1,000•(1 + .90 + .90² + .90³ + ...)
• = $1,000•(1/1-.90)
• = $1,000•(1/.10)
• = $1,000•10
• = $10,000

• = $100•(1 + .90 + .90² + .90³ + ...)
• = $100•10
• = $1,000

• = $900•(1 + .90 + .90² + .90³ + ...)
• = $900•10
• = $9,000

• With required reserve ratio of .10,
  $1,000 supports $10,000 of new deposits.
• The difference, $9,000, is new loans.
• Change in Bank Deposits =
• Change in Reserves•(1/reserve ratio)
• (1/reserve ratio) is deposit multiplier.

• It sells U.S. Treasury securities, draining reserves from the banks.
• short of reserves, banks reduce loans outstanding until they can again meet the reserve requirement.
• When process is complete, deposits in the system have decreased by the decrease in reserves times the deposit multiplier.

• What do they do with all the interest they collect from the U.S. Treasury?
• They employ those 247 Ph.D. economists for one thing!
• Any surplus is recycled to the Treasury.

• Most frequently used,
• the Fed is buying and selling Treasury securities all the time.

• Make it more or less expensive for banks to borrow at discount window.
• Not very important because banks are discouraged from borrowing anyway.
• A bargain, but banks that use it are put on list of "problem banks."

• A change from 5% to 6%, say, would force banks to increase reserves,
• shortage of required reserves,
• banks shrink loans to build reserves,
• so quantity of deposits shrinks.
• Used only very occasionally.