Download CHAPTER 29 – THE MONETARY SYSTEM 3 FUNCTIONS OF

CHAPTER 29 – THE MONETARY SYSTEM
I.
II.
III.
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V.
2001
2007
VI.
VII.
3 FUNCTIONS OF MONEY
a. Medium of Exchange – money facilitates trade and allows buyers and sellers to
purchase/sell goods & services.
b. Unit of Account – money provides a common measure of the value of the goods &
services be exchanged.
c. Store of Value – money holds its value over time and allows individuals to transfer
wealth from one generation to the next over time.
i. Caution – money does decline in value over time due to the erosion that results
from inflation.
LIQUIDITY – how quickly an asset can be converted to cash.
2 KINDS OF MONEY
a. Commodity Money – A country’s currency is backed by some form of commodity
(typically gold). When gold supports the currency, the country is said to be following the
Gold Standard.
b. Fiat Money – a country’s currency is backed only by the full faith of the issuing country’s
government. Money today in the U.S. is Fiat Money. At the top of each dollar, you’ll see
the words FEDERAL RESERVE NOTE.
HOW DO WE MEASURE THE AMOUNT OF MONEY STOCK IN THE COUNTRY?
a. Money Stock – the total quantity of money that is circulating in the economy. It is
comprised of:
i. Currency & coin – M1
ii. Demand deposits – M1
iii. Travelers checks – M1
iv. Savings accounts – M2
v. Timed-deposits (CDs) – M2
vi. Money market accounts – M2
vii. Money market mutual funds – M2
ANALYZING THE MONEY STOCK – COMPARING 2001 WITH 2007
M1
Currency = $580 billion
Total M1 = $1.179 trillion
Currency = $759 billion
Total M1 = $1.364 trillion
M2
$4.276 trillion
TOTAL
$5.455 trillion
$6.083 trillion
$7.447 trillion
WHERE IS ALL THE CURRENCY?
a. Abroad – since it is a strong store of value, foreign countries demand U.S. currency.
b. Black Market Economy – because currency can be tracked, illegal activities often remove
currency from the banking sector and negotiate deals strictly on the basis of cash.
THE FEDERAL RESERVE SYSTEM
a. Created in 1914 as a result of the bank failures in 1907, the Fed is the nation’s central
bank (i.e. – the government’s bank).
b. Federal Reserve Key Points:
i. Run by a 7 member Board of Governors (appointed by the President and
confirmed by the Senate)
ii. Each board member serves a 14-year term so as to not be influenced by politics
iii. The Chairman of the Board (currently Ben Bernanke) is appointed to the
position by the President and serves a 4-year term. Often referred to as the 2nd
most powerful person in the U.S.
iv. Nicknamed the FED; also nicknamed the LENDER OF LAST RESORT b/c
troubled banks (and financial institutions today) can go to the FED Window to
borrow money and remain liquid.
v. Federal Reserved System comprised of 12 regional banks
1.
c.
d.
e.
Each regional bank has its own board of directors comprised of
individuals from the region’s banking and business communities.
2. Each regional bank has its own BANK PRESIDENT.
vi. The FED is similar to a not-for-profit entity in that the revenues that it generates
are used to pay for its normal operating expenses. Any additional revenues (aka
– profit) is paid directly to the Department of Treasury.
THE FED HAS 2 IMPORTANT JOBS:
i. Banking regulation in order to ensure a healthy banking landscape
ii. Control the money supply within the economy.
1. Decisions regarding the money supply are called Monetary Policy.
2. Monetary Policy is the responsibility of the FEDERAL OPEN
MARKET COMMITTEE, which meets every 6 weeks in Washington,
D.C. to consider changes in policy.
THE FEDERAL OPEN MARKET COMMITTEE (FOMC)
i. Made up of 12 members
ii. The 12 members are comprised of the 7 member Federal Reserve Board as well
as 5 regional bank presidents.
iii. All 12 regional bank presidents attend each FOMC meeting, however, only 5 get
to vote on actual policy matters. Voting rights are as follows:
1. The NYFED President always receives a vote because all FED
purchases & sales of U.S. Treasury Bonds take place in New York and
the NYFED’s trading desk handles such trades.
2. The other 4 bank president voting positions are rotated among the
remaining 11 regional bank presidents on a scheduled basis.
FED MONETARY POLICY TOOLS
i. Open Market Operations – the most often used tool to control the supply of
money within the economy. Here’s how it works:
1. When the FED wants to pull money out of circulation in the economy
to slow it down, it will sell treasury bonds from its portfolio to the
public in the nation’s bond markets. Selling bonds, in essence, acts as a
vacuum cleaner, sucking money out of the economy.
2. When the FED wants to put money into circulation to speed up the
economy, it will go into the bond market and buy treasury bonds,
increasing its portfolio. Buying bonds serves to increase the money
available within the economy in hopes of stimulating economic activity.
ii. Reserve Requirement
1. The FED follows a FRACTIONAL RESERVE SYSTEM in which is
requires member banks to keep a fraction of their reserves on hand at
all times. Reserves come from the deposits that have been made at a
bank from the account holders. In other words, banks are not allowed to
loan out everything that they take in from deposits.
2. For a bank, its balance sheet will show that the total amount of funds
deposited will equal the liabilities of the bank while the reserves will
equal the assets of the bank. Think about how it would look on a Taccount.
3. Money Creation with Fractional Reserve Banking
a. Required Reserves – what the bank must keep at all times (i.e.
– the %age of new deposits that are not allowed to be loaned
out)
b. Excess Reserves – the amount of reserves in excess of the
required reserve level that banks are permitted to loan out.
4. How do banks create money?
a. Since banks have Excess Reserves, they can originate loans.
As loans are made, banks create money (and not wealth).
b. The Money Mulitplier
VIII.
i. Simply put, the Money Multiplier is the amount of
money the banking system generates with each dollar
of reserves. If the reserve ratio is 10%, the Money
Mulitplier will equal its reciprocal (or 10). So, if
there are $1,000 in reserves, through new loans, the
banking system can raise the available money supply
to $10,000. If the reserve ratio is 20%, then banks can
only increase the money supply to $5,000 (or 5
times). The higher reserve ratio, the less each
deposit banks can loan out, and the smaller the
money multiplier. The lower the reserve ratio, the
opposite occurs.
ii. If a bank has $1,000,000 in Required Reserves and
a 30% reserve ratio, what is the maximum amount
of loans that they can make?
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iii. If the Reserve Requirement was 100%, the banks
would not make any loans and the money supply
would remain unchanged.
iv. The FED typically does not elect to alter the Reserve
Requirement as a method of altering the economy.
iii. Interest Rates – The FED has, at its disposal, 2 important interest rates.
1. Federal Funds Rate – banks within the Federal Reserve System can
make overnight loans between each other to ensure that they meet the
mandated reserve requirement. When such loans take place, they are
executed at the Fed Funds Rate. Currently, the rate is .25%.
2. Discount Rate – as the lender of last resort, banks and companies can
go directly to the Fed Window and borrow from the Federal Reserve
bank itself. Remember, part of the FED’s responsibility as the nation’s
central bank is to prevent financial collapse within the economy.
During the past few decades, the FED has stepped in and provided
instant liquidity to foreign governments, private financial institutions
and even the capital markets after 9/11.
PROBLEMS IN CONTROLLING THE MONEY SUPPLY
a. 2 problems are encountered by the FED in trying to control Money Supply. They are:
i. The FED cannot impact the amount of money that households elect to deposit in
banks. If households deposit a lot of money, this allows banks, through loans, to
create more money. With fewer deposits, there are fewer reserves which lead to
a smaller money supply. If people lose confidence in the banking system, they’ll
withdrawal all of the funds, crippling the economy in the process. Japan has
experienced this in the last decade.
ii. The FED cannot control the amount of money that banks make in loans.
Because of this, the FED cannot be sure how much money the banking system
will create.
b. THE FINAL RESULT:
i. A key FED responsibility is to establish, based upon its data, an appropriate
level of money supply within the economy. Because it is difficult to predict the
behavior of depositors and banking institutions, which impact the total money
supply, the FED closely watches monetary figures weekly (M1 & M2) to gauge
what is happening within the country. This way, through their own actions
described above (Open Market Operations, Reserve Requirement & Interest
Rates), they can maintain, increase, or decrease the money supply as they deem
necessary.