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The Nature and Creation of Money
Read Chapter 9 pages 184 – 200.
I What is Money?
A) Money is anything that serves as a
medium of exchange.
B) Three Functions of Money.
1) A medium of exchange is anything that is
widely accepted as a means of payment.
Barter occurs when goods are exchanged
directly for other goods.
2) A unit of account is a consistent means of
measuring the value of things.
3) A store of value is an item that holds value
over time.
C) Types of Money
1) Commodity money is money that has value
apart from its use as money.
2) Fiat money is money that some authority has
ordered to be accepted as a medium of
exchange.
Examples:
a) Currency is paper money and coins.
b) Checkable deposits are balances in checking
accounts. A check is a written order to a bank
to transfer ownership of a checkable deposit.
D) Measuring Money
1) The total quantity of money in the
economy at any one time is called the
money supply.
2) Economists refer to the ease with which
an asset can be converted into currency as
the asset’s liquidity.
3) M1 consists of currency in circulation,
checkable deposits and travelers checks.
4) M2 is M1 plus small time deposits.
II The Banking System and Money Creation
A) Banks and other Financial Intermediaries
1) A financial intermediary is an institution
that amasses funds from one group and
makes them available to another.
2) A bank is a type of financial intermediary
which accepts deposits, makes loans, and
offers checking accounts.
B) Bank Finance and a Fractional Reserve
System
1) A balance sheet is a financial statement
showing assets, liabilities and net worth.
2) Assets are anything of value.
3) Liabilities are obligations to other parties.
4) Net worth equals assets less liabilities.
5) Banks keep only a fraction of their deposits
as cash in their vaults and in deposits with
the Fed called reserves.
6) A system in which banks hold reserves
whose value is less than the sum of claims
outstanding on those reserves is called a
fractional reserve banking system.
C) Money Creation
1) The quantity of reserves banks are required to
hold is called required reserves.
2) The reserve requirement is the ratio of reserves
to checkable deposits.
3) Excess reserves are reserves that a bank holds
in excess of the required level.
4) Excess reserves plus required reserves equal
total reserves.
5) When a banks excess reserves are zero, it is
loaned up.
D) Money Creation Illustration
1) Bank (Acme Bank) is initially loaned up.
2) Next they receive a deposit of $1,000
3) The bank has excess reserves of $900.
4) So they make a loan for $900 increasing
their loans and deposits by $900.
5) The person who receives the loan buys a
stereo and writes a check for $900 to
someone with an account at Bellville
Bank.
6) Now the steps repeat.
E) The Deposit Multiplier
1) The deposit multiplier equals the ratio of
the maximum possible change in
checkable deposits to the change in
reserves.
2) Md =
Change in deposits/Change in reserves.
3) Md = 1/reserve ratio.
example: reserve ratio of .1 implies
deposit multiplier of 10.
F) The regulation of banks.
1) Deposits Insurance provided by the FDIC
2) Regulated to maintain a minimum level of
net worth as a fraction of total assets.
III The Federal Reserve system
A) A central Bank performs four primary
functions:
1) acts as a banker to the government,
2) acts as a banker to banks,
3) acts as a regulator of banks,
4) sets monetary policy.
B) Structure of the Fed
1) 12 regional branches.
2) 7 members of the Board of Governors
located in Washington.
3) Federal Open Market committee consists
of the 7 BOG members plus 5 regional
bank presidents who serve on a rotating
basis.
4) Fed decides policy independent of
political demands.
C) Powers of the Fed
1) Set Reserve Requirements.
2) Sets the discount rate which is the interest
rate that banks can borrow from the Fed at
on overnight loans.
3) Targets the Federal Funds rate which is the
interest rate that banks can borrow from
the other banks on overnight loans.
D) Implementation of Monetary policy
• Carried out by the New York Fed
President who is a permanent member of
the FOMC.
2) Done using open market operations which
occur when the Fed buys and sells federal
government bonds on the open market.
E) Impact on the Money Supply.