Bài giảng Macroeconomics - Chapter 3: Money and prices in the long-run - Nguyễn Thùy Dung

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TOPIC 3
MONEY AND PRICES 
IN THE LONG-RUN
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This section will help you:
▪ Define money and discuss its functions.
▪ Discuss the definition of the money supply.
▪ Explain how financial institutions create money.
▪ Understand tools of Monetary Control
3.1 The monetary system 
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Trade without money
▪Most people have to spend time searching for 
others to trade with – a huge waste of resources. 
▪ Trade without money is known as 
direct exchange, or barter
▪ Barter is inefficient because there must be a coincidence 
of wants. For trade to take place, each must want what 
the other person has, and must be willing to trade for it
▪ This searching is unnecessary with money, 
▪ It facilitates production and trade: people accept 
money for their own products, and then use 
money to purchase other goods and services.
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Indirect Trade
Money makes trade 
much more efficient
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Money: the set of assets in an economy that people 
regularly use to buy g&s from other people
Money
Medium 
of exchange
Unit of 
account
Store of 
value
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The 3 Functions of Money
▪ Medium of exchange: an item buyers give to 
sellers when they want to purchase g&s.
✓Liquidity to describe the ease with which an asset 
can be converted into the economy’s medium of 
exchange
▪ Unit of account: is an agreed measure for 
stating the prices of g&s and record debts 
▪ Store of value: an item people can use to 
transfer purchasing power from the present to 
the future
one good to be compared with another.
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The 2 Kinds of Money
Commodity money: 
takes the form of a commodity 
with intrinsic value
Examples: gold, silver, shell, 
cigarettes
Fiat money: 
money without intrinsic value,
is used as money because of 
government decree.
Example: the U.S. dollar
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The Money Supply
▪ The money supply (or money stock):
the quantity of money available in the economy
▪ Assets should be considered as part of MS:
▪ Currency: the paper bills and coins in the 
hands of the public.
▪ Demand deposits: balances in bank accounts 
that depositors can access on demand by 
writing a check or swiping a debit card.
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Measures of the Money Supply
The two most commonly used measures of the money stock, 
designated M1 and M2
Defines money according to its liquidity
▪ Currency
▪ Demand deposits
▪ Traveler’s checks
▪ Other checkable deposits ▪ Everything in M1
▪ Savings deposits
▪ Small time deposits
▪ Money market mutual 
funds
M1 M2
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Central Banks & Monetary Policy
▪ Central bank: an institution that oversees the 
banking system and regulates the money supply
▪ Monetary policy: the setting of the money 
supply by policymakers in the central bank
▪ Federal Reserve (Fed): responsible for 
regulating the system - an example of central 
bank in U.S. 
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The Fed’s Organization
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The Structure of the Fed
The Federal Reserve System consists of:
▪ Board of Governors
(7 members), located in Washington, DC
▪ 12 regional Fed banks, located around the U.S.
▪ Federal Open Market Committee (FOMC), 
includes the Board of Governors and Presidents of 
some of the regional Fed banks 
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US Dollar 
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▪ The Fed’s functions
– Regulate banks & ensure the health of the 
banking system
– control the quantity of money that is made 
available in the economy, called the money 
supply
▪ At the Fed, monetary policy is made by the 
Federal Open Market Committee (FOMC).
The Structure of the Fed
ngân hàng của các ngân hàng. Fed 
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Federal Open Market Committee
▪ Fed’s primary tool: open-market operation
• Purchase & sale of U.S. government bonds
➢ FOMC - increase the money supply
• Open-market purchase (buy bonds)
➢ FOMC - decrease the money supply
• Open-market sale (sell bonds)
increase or decrease the number 
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Bank T-account
▪ T-account: a simplified accounting statement 
that shows a bank’s assets & liabilities.
▪ Example:
▪ Banks’ liabilities include deposits, 
assets include loans & reserves. 
NATIONAL BANK
Assets Liabilities
Reserves $ 10
Loans $ 90
Deposits $100
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Banks the Money Supply: An Example
Suppose $100 of currency is in circulation. 
To determine banks’ impact on money supply, 
we calculate the money supply in 3 different cases: 
1. No banking system
2. 100% reserve banking system
3. Fractional reserve banking system
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Banks and the Money Supply
▪ Reserves: Deposits that banks have received but 
have not loaned out
▪ The Fed establishes reserve requirements - the 
minimum amount of reserves that banks must 
hold against deposits.
▪ Banks may hold more than this minimum 
amount, called excess reserve 
▪ The reserve ratio, R
= total reserves as a percentage of total deposits 
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Banks and Money Supply: An Example
CASE 1: No banking system
Public holds the $100 as currency. 
➔ Money supply = $100. 
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Banks and Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits $100 at First National Bank (FNB). 
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
Loans $ 0
Deposits $100
FNB holds 100% 
of deposit as 
reserves: 
➔ Money supply 
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system, 
banks do not affect size of money supply.
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Banks and Money Supply: An Example
CASE 3: Fractional reserve banking system
➔ FNB creates an additional $90 of money.
MS includes: Depositors have $100 in deposits, 
Borrowers have $90 in currency.
Suppose R = 10%. FNB loans all but 10% 
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10
Loans $ 90
Deposits $100
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Banks and Money Supply: An Example
SECOND NATIONAL BANK
Assets Liabilities
Reserves $ 9
Loans $ 81
Deposits $ 90
Suppose borrower deposits $90 at Second National 
Bank (SNB).
CASE 3: Fractional reserve banking system
➔ SNB creates an additional $81 of money.
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CASE 3: Fractional reserve banking system
THIRD NATIONAL BANK
Assets Liabilities
Reserves $ 8.1
Loans $ 72.9
Deposits $ 81
The borrower deposits $81 at Third National Bank 
(TNB).
Banks and Money Supply: An Example
Each time that money is deposited and a bank loan is 
made, more money is created.
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CASE 3: Fractional reserve banking system
The process continues, and money is created with 
each new loan. 
Original deposit =
SNB deposit =
TNB deposit = 
FNB deposit = 
...
$ 100.00
$ 90.00
$ 81.00
$ 72.90
...
Total money supply = $
Banks and Money Supply: An Example
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The Money Multiplier
▪ Money multiplier (or Deposit Expansion 
Multiplier): the amount of money the banking 
system generates with each dollar of reserves
▪ The money multiplier equals 1/R. 
▪ In our example, 
R = 10%, money multiplier = 1/R = 10 
Meaning bank holds a total of $100 in reserves, 
it can have only $1,000 in deposits
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CASE 4: Excess reserves example
Banks and Money Supply: An Example
➔Money supply = $160
Excess reserves reduce the money supply
Suppose R = 10%. FNB loans all but 40% of the 
deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10
Excess reserves $ 30
Loans $ 60
Deposits $100
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A C T I V E L E A R N I N G 1
Banks and the money supply
You deposit $50 in your checking account. 
The Fed’s reserve requirement is 20% of deposits.
A. What is the maximum amount that the 
money supply could increase? 
B. What is the minimum amount that the 
money supply could increase? 
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If banks hold no excess reserves, then 
money multiplier = 1/R = 1/0.2 = 5
The maximum possible amount of deposits is 
5 x $50 = $250
But currency falls by $50, then MS falls by $50 
Hence, max increase in money supply = $200.
You deposit $50 in your checking account.
A. What is the maximum amount that the 
money supply could increase? 
A C T I V E L E A R N I N G 1
Answers
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• Assets: 
– Besides reserves and loans, banks also hold 
securities. 
• Liabilities: 
– Besides deposits, banks also obtain funds 
from issuing debt and equity
• Bank capital: 
– The resources a bank obtains by issuing 
equity to its owners
A More Realistic Balance Sheet
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A More Realistic Balance Sheet
• Leverage ratio: ratio of assets to bank capital
In this example, the leverage ratio = $1000/$50 = 20
Meaning for every $20 in assets, .
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Leverage Amplifies Profits and Losses
• Suppose value of bank assets increase by 5%, from 
$1000 to $1050. 
– increases bank capital from $50 to $100
• Instead, if value of bank assets decrease by 5%, 
– Bank capital falls from $50 to $0. 
• If value of bank assets decrease more than 5%, 
– Bank capital is negative and bank is insolvent. 
➔ Bank regulators require banks to hold a certain 
amount of capital, called Capital requirement.
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The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase 
and sale of U.S. government bonds by the Fed.
▪ To increase money supply, Fed buys govt bonds, 
paying with new dollars
▪ To reduce money supply, Fed sells govt bonds, 
taking dollars out of circulation, and the process 
works in reverse.
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The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR): affect how much 
money banks can create by making loans. 
▪ To increase money supply, Fed reduces RR. 
Banks make more loans which increases money 
multiplier and money supply.
▪ To reduce money supply, Fed raises RR.
▪ Fed rarely uses reserve requirements to control 
money supply
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The Fed’s 3 Tools of Monetary Control
3. The Discount Rate: the interest rate on loans the 
Fed makes to banks
▪ When banks are running low on reserves 
they may borrow reserves from the Fed. 
▪ To increase money supply, 
Fed can lower discount rate, which encourages 
banks to borrow more reserves from Fed. 
▪ To reduce money supply, Fed can raise discount rate. 
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The Federal Funds Rate
▪ Banks with insufficient reserves can borrow from 
banks with excess reserves. 
→ Federal funds rate: the interest rate at which banks 
make overnight loans to one another
▪ The FOMC uses OMOs to target the fed funds rate. 
▪ Many interest rates are highly correlated, 
so changes in the fed funds rate cause changes in 
other rates and have a big impact in the economy.
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Monetary Policy & the Fed Funds Rate
To raise fed funds 
rate, Fed sells 
govt bonds (OMO). 
This removes 
reserves from the 
banking system, 
→ reduces MS
causes rf to rise.
rf
F
D1
S2
3.75%
F2
S1
F1
3.50%
The Federal 
Funds market
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Problems Controlling the Money Supply
▪ If households hold more of their money as 
currency, banks have fewer reserves, make 
fewer loans ➔ money supply falls.
▪ If banks hold more reserves than required, 
they make fewer loans ➔ money supply falls. 
▪ Being aware of any changes in depositor or 
banker behavior Fed can respond to these 
changes and keep the money supply close to 
whatever level it chooses