SECTION 3

MONEY AND PRICES IN

THE LONG RUN

1
 CHAPTER 29
1 The Monetary System
SECTION 3
Money And Prices
In The Long Run CHAPTER 30
2 Money Growth and Inflation
CHAPTER 29:
The Monetary System

3
 UNIT OUTLINE

1 Tổng quan về hoạt động kinh doanh NHTM

The Meaning Of Money
2 The Federal Reserve System
3 Banks and the Money Supply
4 The Fed’s Tools of Monetary Control

4
1. The Meaning Of Money

5 5
 THE MEANING OF MONEY

If there is no money, the trade is done by

Money the barter method.

Every transaction requires a double

Money is the set of coincidence of wants — that is, everyone
assets in the economy has a product that everyone else wants.

that people regularly People will have to spend time looking

for people to trade – thereby wasting a
use to buy goods and lot of resources.
services from each
This search will be overcome if money is
other. used. Money is understood as assets
used to purchase goods and services.
6
 THE FUNCTIONS OF MONEY

Medium of exchange an item that buyers give Unit of account

the yardstick people use
to sellers when they want
to post prices and record
to purchase goods and
debts.
services.

Store of value Liquidity the ease with which an

an item that people can
use to transfer purchasing asset can be converted
power from the present to into the economy’s
the future. medium of exchange.

7
 THE KINDS OF MONEY

Commodity Money Fiat Money

Money that takes the Money without intrinsic

form of a commodity value that is used as
with intrinsic value. money by government
decree.

8
 MONEY IN THE U.S. ECONOMY

Two Measures of the Money Stock

for the U.S. Economy
$14,467
Currency is the paper bills and coins
in the hands of the public.

Billions of Dollars
• Savings deposits
• Small time deposits
• Money market mutual funds
• A few minor categories

Demand deposits are balances in bank

accounts that depositors can access •
•
Currency
Demand deposits • Everything in M1

on demand by writing a check. •

•
Traveler’s checks
Other checkable deposits
($3.737 billion)

$0,000
M1 M2

The two most widely followed measures of the money stock are M1
and M2. This figure shows the size of each measure in January 2019.

9
2. The Federal Reserve System

10 10
 THE FED’S ORGANIZATION

Federal Reserve (Fed) Central Bank

An institution designed to oversee
The central bank of the United States the banking system and regulate the
quantity of money in the economy.

Money Supply Monetary Policy

The setting of the money supply by
The quantity of money available in
policymakers in the central bank
the economy.

11
THE FEDERAL OPEN MARKET COMMITTEE

Central banks are important institutions because changes in the money supply
can profoundly affect the economy.

One of the Ten Principles of Economics in Chapter 1 is that prices rise when the
government prints too much money.

Another of the Ten Principles of Economics is that society faces a short-run

trade-off between inflation and unemployment.

The Fed’s policy decisions are key determinants of inflation in the long run and
employment and production in the short run.

12
 THE FEDERAL OPEN MARKET COMMITTEE

QuickQuiz

Which of the following is NOT true about the If the Fed wants to increase the money
Federal Reserve? supply, it can

a. It was established
established by
by the
the U.S.
U.S.Constitution.
Constitution. a. raise income tax rates.

b. It regulates the banking system. b. reduce income tax rates.

c. It lends to banks. c. buy bonds in open-market

open-marketoperations.
operations.

d. It conducts open-market operations. d. sell bonds in open-market operations.

13
3. Banks And Money Supply

14 14
THE SIMPLE CASE OF 100-PERCENT-RESERVE BANKING

Reserves are deposits that banks have received but have not
loaned out.

In this imaginary economy, all deposits are held as reserves, so this system is
called 100-percent-reserve banking.

Each deposit in the bank reduces currency and

First National Bank raises demand deposits by exactly the same
Assets Liabilities amount, leaving the money supply unchanged.
Thus, if banks hold all deposits in reserve, banks
Reserves $100 Deposits $100 do not influence the supply of money.

15
MONEY CREATION WITH FRACTIONAL-RESERVE BANKING

Fractional-reserve Banking is a banking system in which banks

hold only a fraction of deposits as reserves.

Reserve ratio the fraction of deposits that banks hold as reserves.

• This ratio is influenced by both government regulation and bank policy.

Reserve requirement is the rate at which the Fed sets a minimum amount
of reserves that banks must hold.

Excess reserves is banks may hold reserves above the legal minimum.
• So, they can be more confident that they will not run short of cash

16
 MONEY CREATION WITH FRACTIONAL-RESERVE BANKING
Now, let’s look again at the bank’s T-account:

First National Bank • The bank's liabilities include deposits, the bank's assets
Assets Liabilities
include loans and reserves.
Reserves $10 Deposits $100
• In this case, R = $10/$100 = 10%.
Loans $90

q Before First National makes any loans, the money supply is the $100 of deposits. Yet when First National lends out
some of these deposits, the money supply increases. The depositors still have demand deposits totaling $100, but now
the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190.
Thus, when banks hold only a fraction of deposits in reserve, the banking system creates money.

q However, as a bank creates the asset of money, it also creates a corresponding liability for those who borrowed the
created money. At the end of this process of money creation, the economy is more liquid in the sense that there is
more of the medium of exchange, but the economy is no wealthier than before.

17
MONEY CREATION WITH FRACTIONAL-RESERVE BANKING

Example:
Assume there is $100 in cash in
circulation. To determine the
impact of banks on the money
supply, calculate the money
supply in the following three
cases:
1. There is no banking system.
2. 100% reserve banking system: a
bank that keeps 100% of deposits
as reserves, does not lend.
3. Proportional reserve banking
system.
Case 1: There is no banking system
• People hold $100 cash.
• Money supply = $100.
Case 2: 100% reserve banking system.
People deposit $100 at First National Bank (FNB).
First National Bank
Assets Liabilities Amount of money supply =
= cash + deposit
Reserves $10 Deposits $100 = $0 + $100 = $100
Loans $0
q In the 100% reserve banking system, banksdoes not affect the
size of the money supply.

18
 MONEY CREATION WITH FRACTIONAL-RESERVE BANKING
Case 3: Proportional reserve banking system. Let's say R = 10% Case 3: Proportional reserve banking system. Borrowers of SNB
deposit $81 in the BankThird Country (TNB). If TNB has R = 10%.
First National Bank
Assets Liabilities
Third National Bank
Assets Liabilities
Reserves $10 Deposits $100
Reserves $8.1 Deposits $81
Loans $90
Loans $72.9
Amount of money supply = cash + deposit = $90 + $100 = $190
When banks lend money, they make money. Borrowers receive:
• $90 cash: this asset is included in the money supply. Case 3: Proportional reserve banking system. The process goes on
• $90 new debt: this debt has no compensating effect on the and on. Each time that money is deposited and a bank loan is made,
money supply. more money is created.
q The proportional reserve banking system creates money,
but not wealth. Original deposit = $100.00
First National lending = $ 90.00 ( .9 x $100)
Case 3: Proportional reserve banking system. People deposit Second National lending = $ 81.00 ( .9 x $90)
$90 at Second National Bank (SNB). If SNB has R=10%. Third National lending = $ 72.90 ( .9 c $81)
. .
Sencond National Bank
. .
Assets Liabilities

Reserves $9 Deposits $90 Total money supply = $1,000.00

Loans $81
19
 THE MONEY MULTIPLIER

Money multiplier is the amount of money the banking system

generates with each dollar of reserves.

1
Money multiplier =
R

q In the above example, R = 10%; Money multiplier = 1/R = 10; $100 in reserve generates $1000.
q Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the
money multiplier. In the special case of 100-percent-reserve banking, the reserve ratio is 1, the
money multiplier is 1, and banks do not make loans or create money.

20
 THE MONEY MULTIPLIER

q A bank gets financial resources not only from More Realistic National Bank
accepting deposits but also, like other Assets Liabilities and Owners’ Equity
companies, from issuing equity and debt.
Reserves $200 Deposits $800
Loans 700 Debt 150
The resources that a bank obtains from Securities 100 Capital (owners’ equity) 50
issuing equity to its owners are called
bank capital.
• The value of the owners’ equity is, by definition,
the value of the bank’s assets (reserves, loans,
A bank uses these financial resources in various and securities) minus the value of its liabilities
ways to generate profit for its owners. It not only (deposits and debt).
makes loans and holds reserves but also buys • Therefore, the left and right sides of the balance
financial securities, such as stocks and bonds. sheet always sum to the same total.

21
BANK CAPITAL, LEVERAGE, AND THE FINANCIAL CRISIS OF 2008–2009

Leverage is the use of borrowed money to supplement existing funds

for purposes of investment.

• Many businesses rely on leverage, the use of borrowed money to supplement existing funds for
investment purposes. Indeed, whenever a business uses debt to finance an investment project,
it is applying leverage.

Leverage ratio is the ratio of assets to bank capital.

q For example, the leverage ratio is $1,000/$50, or 20. A leverage ratio of 20 means that for every
dollar of capital that the bank owners have contributed, the bank has $20 of assets. Of the $20
of assets, $19 are financed with borrowed money—either by taking in deposits or issuing debt.

22
BANK CAPITAL, LEVERAGE, AND THE FINANCIAL CRISIS OF 2008–2009

Capital requirement
is a government regulation specifying a minimum amount of bank capital.

Bank regulators require banks to hold a certain amount of capital.

The goal of such a capital requirement is to ensure that banks will be able to pay
off their depositors (without having to resort to government-provided deposit
insurance funds).

The amount of capital required depends on the kind of assets a bank holds. A
bank holding risky assets such as loans to borrowers whose credit is of dubious
quality would be, all other things equal, required to hold more capital than a bank
holding safe assets such as government bonds.
23
 QUICKQUIZ

QuickQuiz
Isabella takes $100 of currency from If the reserve ratio is 14 and the A bank has capital of $200 and a
her wallet and deposits it into her central bank increases the quantity of leverage ratio of 5. If the value of the
checking account. If the bank adds the reserves in the banking system by bank’s assets declines by 10 percent, then
entire $100 to reserves, the money supply $120, the money supply increases by its capital will be reduced to
_________, but if the bank lends out some
of the $100, the money supply _________.

a. increases; increases even more a. $90. a. $100.

b. increases; increases by less b. $150. b. $150.

c. is unchanged;
unchanged; increases
increases c. $160. c. $180.

d. decreases; decreases by less d. $480. d. $185.

24
4. The Fed’s Tools Of Monetary Control

25 25
 THE FED’S TOOLS OF MONETARY CONTROL

The Fed has various tools in its monetary toolbox. We can group the tools into two groups:

THE QUANTITY OF THE RESERVE RATIO AND IN

RESERVES TURN THE MONEY MULTIPLIER

Money supply = Money multiplier x Bank reserves

• The Fed can change the money supply by changing the bank's reserve ratio or by changing the money multiplier.
26
HOW THE FED INFLUENCES THE QUANTITY OF RESERVES

The first way the Fed can change the money supply is by changing the quantity of
reserves. The Fed alters the quantity of reserves either by buying or selling bonds in open-
market operations or by making loans to banks (or by some combination of the two).

Central Bank
Open-market Operations are the purchase and sale of U.S.
Customer Bank
government bonds by the Fed.

q If the Fed buys government bonds from a bank, the Fed pays
by depositing new reserves in the bank.

q With more reserves, banks can lend more, thereby increasing

the money supply.

q To reduce bank reserves and the money supply, the Fed will
sell government bonds.

27
HOW THE FED INFLUENCES THE QUANTITY OF RESERVES

q The Fed lends money to banks, increasing reserves.

– Traditional method: adjust the discount rate — the rate at which the Fed lends money to
banks — thereby affecting the bank's level of reserves.
– New method: Term Loan Auction— The Fed chooses a loan reserve, which banks then
bid against each other to borrow this loan.

q The more banks borrow, the more reserves they have to lend and thereby increase
the money supply.

28
HOW THE FED INFLUENCES THE RESERVE RATIO

q Reserve ratio = reserve/deposit level, which affects the money multiplier.

q Reserve requirements: are regulations on the minimum amount of

reserves that a bank must keep from deposits.

q Reducing the reserve requirement will decrease the reserve requirement

ratio and increase the money multiplier.

29
PROBLEMS IN CONTROLLING THE MONEY SUPPLY

q The first problem is that the Fed does not control the amount of money
that households choose to hold as deposits in banks.

q The second problem of monetary control is that the Fed does not control
the amount that bankers choose to lend.

• Hence, in a system of fractional-reserve banking, the amount of money in the economy depends in
part on the behavior of depositors and bankers.
• Yet if the Fed is vigilant, these problems need not be large. The Fed collects data on deposits and
reserves from banks every week, so it quickly becomes aware of any changes in depositor or banker
behavior. It can, therefore, respond to these changes and keep the money supply close to whatever
level it chooses.

30
CHAPTER 30:
Money Growth and
Inflation

31
 UNIT OUTLINE

1 Tổng quan về hoạt động kinh doanh NHTM

The Classical Theory of Inflation

2 The Costs of Inflation

3 Conclusion

32
1. The Classical Theory of Inflation

33 33
 THE LEVEL OF PRICES AND THE VALUE OF MONEY

We begin our study of inflation by developing the quantity theory of money. This theory is often
called “classical” because it was developed by some of the earliest economic thinkers. Most
economists today rely on this theory to explain the long-run determinants of the price level and
the inflation rate.

The Level of Prices and the Value of Money

When the overall price level rises, the value of money falls.

à In the long run, money supply and money demand are brought into equilibrium by
the overall level of prices.

34
MONEY SUPPLY, MONEY DEMAND, AND MONETARY EQUILIBRIUM

The two curves in this figure are the

supply and demand curves for money.
• The supply curve is vertical.
• The demand curve for money
slopes downward, indicating that
when the value of money is low
(and the price level is high.
• At the equilibrium (A), the quantity
of money demanded balances the
quantity of money supplied. This
equilibrium of money supply and
money demand determines the
value of money and the price level.

35
MONEY SUPPLY, MONEY DEMAND, AND MONETARY EQUILIBRIUM

Quantity Theory
Of Money:
a theory asserting that
the quantity of money
available determines
the price level and
that the growth rate in
the quantity of money
available determines
the inflation rate.

36
 A BRIEF LOOK AT THE ADJUSTMENT PROCESS

§ The greater demand for goods and services à The prices of goods and services to increase.
§ The increase in the price level, in turn, increases the quantity of money demanded because people are
using more dollars for every transaction.
§ Eventually, the economy reaches a new equilibrium (point B in Figure 2) at which the quantity of
money demanded again equals the quantity of money supplied.

à In this way, the overall price level for goods and services adjusts to bring money supply and money demand
into balance.

37
 THE CLASSICAL DICHOTOMY AND MONETARY NEUTRALITY

Nominal Variables Real Variables

01 Variables measured in monetary 02 Variables measured in physical
units. units.

Classical Dichotomy Monetary Neutrality

The proposition that changes in the
03 The theoretical separation of nominal 04 money supply do not affect real variables.
variables and real variables

38
 VELOCITY AND THE QUANTITY EQUATION

Velocity Of Money
The rate at which money changes hands.

With slight algebraic rearrangement, this equation can be

To calculate the velocity of money: rewritten as:
MxV=PxY
V = (P x Y)/ M
à Quantity equation:
• P : the price level (the GDP deflator)
• Y : the quantity of output (real GDP) Which relates the quantity of money, the velocity of
• M : the quantity of money money, and the dollar value of the economy’s output of
goods and services.

39
VELOCITY AND THE QUANTITY EQUATION

40
 VELOCITY AND THE QUANTITY EQUATION

We now have all the elements necessary to explain the equilibrium price level and inflation rate. They are
as follows:
1. The velocity of money is relatively stable over time.
2. Because velocity is stable, when the central bank changes the quantity of money (M), it causes
proportionate changes in the nominal value of output (P 3 Y).
3. The economy’s output of goods and services (Y) is determined by factor supplies (labor, physical
capital, human capital, and natural resources) and the available production technology. In particular,
since money is neutral, money does not affect output.
4. Because output (Y) is fixed by factor supplies and technology, when the central bank alters the
money supply (M) and induces a proportional change in the nominal value of output (P 3 Y), this
change is reflected in a change in the price level (P).
5. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of
inflation.
à These five points are the essence of the quantity theory of money.
41
THE INFLATION TAX

Inflation Tax

The revenue the government

raises by creating money.
• The inflation tax is like a tax on
everyone who holds money.

42
 THE FISHER EFFECT

The real interest rate is the nominal interest rate minus the inflation rate:

Real interest rate = Nominal interest rate - Inflation rate

à When the Fed increases the rate of money growth, the long-run result is both a higher
inflation rate and a higher nominal interest rate.

Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate.

43
THE FISHER EFFECT

44
 QUICKQUIZ

QuickQuiz
The classical principle of monetary If nominal GDP is $400, real GDP According to the quantity theory of
neutrality states that changes in the is $200, and the money supply is $100, money, which variable in the quantity
money supply do not influence _________ then equation is most stable over long periods
variables, and it is thought most of time?
applicable in the _________ run.

a. nominal; short a. the price level is ½, and velocity is 2. a. money

b. nominal; long b. the price level is ½, and velocity is 4. b. Velocity

c. real; short c. the price level is 2, and velocity is 2. c. price level

d. real; long
long d. the price level
level is
is 2,
2,and
andvelocity
velocityisis4.4. d. output

45
 QUICKQUIZ

QuickQuiz
Hyperinflation occurs when the government runs According to the quantity theory of money and
a large budget _________, which the central bank the Fisher effect, if the central bank increases the
finances with a substantial monetary _________. rate of money growth, then

a. deficit; contraction a. inflation and the nominal interest rate both increase.

b. deficit; expansion b. inflation and the real interest rate both increase.

c. surplus; contraction c. the nominal interest rate and the real interest rate

d.
d. surplus;
surplus; expansion both increase.
d. inflation,
d. inflation, the
the real
real interest
interest rate,
rate, and
and the
the nominal
nominal
interest rate
interest rate all increase.

46
2. The Costs of Inflation

47 47
 THE COSTS OF INFLATION

A Fall in Purchasing Power? The Inflation Fallacy

Inflation does not in itself reduce people’s real purchasing power.

Shoeleather Costs

Shoeleather Costs
The resources wasted when inflation encourages people to
reduce their money holdings

48
 THE COSTS OF INFLATION

Menu Costs: The costs of changing prices

Relative-Price Variability and the Misallocation of Resources

Through these decisions,

Consumers decide what to
That market economies they determine how the
buy by comparing the quality
rely on relative prices to scarce factors of production
and prices of various goods
allocate scarce resources. are allocated among
and services.
industries and firms.

When inflation distorts relative prices, consumer decisions are distorted and
markets are less able to allocate resources to their best use.

49
INFLATION-INDUCED TAX DISTORTIONS

Almost all taxes distort incentives, cause people to alter their behavior,
and lead to a less efficient allocation of the economy’s resources. Many
taxes, however, become even more problematic in the presence of
inflation.

In this case, the 25 percent tax on

interest income reduces the real
interest rate from 4 percent to 1
percent. Because the after-tax real
interest rate provides the incentive to
save, saving is much less attractive in
the economy with inflation (Economy
B)than in the economy with stable
prices (Economy A).

50
 CONFUSION AND INCONVENIENCE

• It is difficult to judge the costs of the confusion and inconvenience that arise from

inflation.

Ø Therefore, to some extent, inflation makes investors less able to sort successful firms

from unsuccessful firms, impeding financial markets in their role of allocating the

economy’s saving among alternative types of investment.

51
 A SPECIAL COST OF UNEXPECTED INFLATION

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

• Inflation has another cost, however, when it comes as a surprise.
• Unexpected inflation redistributes wealth among the population in a way that has nothing to do with
either merit or need. These redistributions occur because many loans in the economy are specified in
terms of the unit of account—money.

Ø This cost of unexpected inflation is important to consider together with another fact: Inflation is
especially volatile and uncertain when the average rate of inflation is high.

If a country pursues a high-inflation monetary policy, it will have to bear not only the costs of high
expected inflation but also the arbitrary redistributions of wealth associated with unexpected
inflation.

52
 INFLATION IS BAD, BUT DEFLATION MAY BE WORSE

• Some economists have suggested that a small and predictable amount of deflation may be desirable.
Milton Friedman pointed out that deflation would lower the nominal interest rate (via the Fisher effect)
and that a lower nominal interest rate would reduce the cost of holding money.
• The shoeleather costs of holding money would, he argued, be minimized by a nominal interest rate
close to zero, which in turn would require deflation equal to the real interest rate.
à This prescription for moderate deflation is called the Friedman rule.

Ø Perhaps most important, deflation often arises from broader macroeconomic difficulties.
This fall in aggregate demand can lead to falling incomes and rising unemployment. In other words,
deflation is often a symptom of deeper economic problems.

53
 THE COSTS OF INFLATION

QuickQuiz
Ongoing inflation does not If an economy always has Because most loans are written in
automatically reduce most people’s inflation of 10 percent per year, which _________ terms, an unexpected increase in
incomes because of the following costs of inflation will it inflation hurts _________.

a. the tax code is fully indexed for NOT suffer?

inflation a. real; creditors
a. shoeleather costs from reduced
holdings of money b. real; debtors
b. people respond to inflation by holding
less money. b. menu costs from more frequent c. nominal; creditors
creditors
price adjustment
c. wage inflation goes together with d. nominal; debtors
price inflation.
inflation. c. distortions from the taxation of
nominal capital gains
d. higher inflation lowers real interest d. arbitrary redistributions
arbitrary redistributions between
rates. creditors
debtors and creditors

54
3. Conclusion

55 55
 CONCLUSION

q This chapter discussed: The causes and costs of inflation.

The primary cause of inflation is growth in the quantity of money.

The costs of inflation are more subtle. They include shoeleather

costs, menu costs, increased variability of relative prices, unintended
changes in tax liabilities, confusion and inconvenience, and arbitrary
redistributions of wealth

56