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Chapter 15
The Monetary System
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The Meaning of Money
Money
is the set of
assets in the economy
that people regularly use
to buy goods and
services from other
people.
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Three Functions of Money
 Medium of Exchange: anything that
is readily acceptable as payment.
 Unit of Account: serves as a unit of
account to help us compare the
relative values of goods.
 Store of Value: a way to keep some of
our wealth in a readily spendable form
for future needs.
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The Two Types of Money
Commodity
Money: something that
performs the function of money and
has alternative, nonmonetary uses.
– Examples: Gold, silver, cigarettes
Fiat
Money: something that serves
as money but has no other important
uses.
– Examples: Coins, currency, check
deposits
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Money in the U.S. Economy
Money
Stock is the quantity of money
circulating in the economy.
Different ways of measuring the money
stock in the economy:
– M1
– M2
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Measurement of Money
The
most familiar
form of money used
includes:
– Coins
– Currency
– Check Deposits
– Travelers Checks
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M1
Measurement of Money
A
broader measure of
money than M1, includes:
– M1 +
– Savings Deposits +
– Small Time Deposits +
– Money Market Mutual
Funds +
– and other minor
categories
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M2
Where is All The Currency?
In
1996 there was about $380 billion of
U.S. currency outstanding ($1,900 in
currency per person).
Location of outstanding currency may
include:
– Currency held abroad
– Currency held by illegal entities
– Currency held in businesses for transaction purposes
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Quick Quiz!
List
and
describe the
three functions
of money.
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The Federal Reserve
Federal Reserve (“Fed”) serves as
the nation’s central bank, which is
designed to oversee the banking
system and regulate the quantity of
money in the economy.
The “Fed” is a privately owned
institution, authorized in 1914 by
Congress to ensure the health of the
nation’s banking system.
The
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The Fed’s Organization
The
Fed is run by its Board of
Governors.
– Seven members appointed by the
President of the United States.
– The Chairman of the Board is the most
important position: presiding, directing,
and testifying about Fed policy. She/He is
appointed by the President.
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The Fed’s Organization
The
Federal Reserve System is made
up of the Federal Reserve Board in
Washington, D.C. and twelve regional
Federal Reserve Banks.
Monetary policy is made by the Federal
Open-Market Committee.
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Three Primary Functions of the Fed
 Regulate the private banking
industry to make sure banks follow
federal laws intended to promote
safe and sound banking practices.
 Act as a banker’s bank, making
loans to other banks and as a lender
of last resort.
 Control of the supply of money i.e.
Monetary Policy.
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Money Supply Changes by the Fed
Open-Market
Operations: The primary
way in which the Fed changes the
money supply done through the
purchase and sale of U.S. government
bonds with newly printed money.
– To increase the money supply, the Fed
buys government bonds from the public.
– To decrease the money supply, the Fed
sells government bonds to the public.
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Quick Quiz!
How
does the
Fed increase the
supply of money
in the economy?
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Banks and The Money Supply
The
behavior of banks can influence
the quantity of demand deposits in the
economy and therefore, the money
supply.
Fractional Reserve Banking System:
The practice of holding a fraction of
money deposited as reserves and
lending out the rest.
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Fractional Reserve Banking
Deposits
into a bank are recorded as
both assets and liabilities. Deposits
that have been received but not lent
out are called reserves.
The supply of money in the economy
is affected by the amount of deposits
that are kept in the bank as reserves
and the amount that is lent out. Loans
become an asset to the bank.
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Bank “T-Account” Example
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
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Total Liabilities
$100.00
Bank “T-Account” Example
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
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Total Liabilities
$100.00
A “T-Account”
illustrates the
financial position
of a bank that
accepts deposits,
keeps a portion as
reserves and lends
out the rest.
Money Creation with
Fractional-Reserve Banking
When
a bank makes a loan (from it’s
reserves) the money supply increases.
When banks hold only a fraction of
deposits in reserve, banks create
money.
The creation of money through loans
does not create any wealth, but allows
banks to charge interest several times
on the same bit of wealth.
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The Money Multiplier
When
one bank loans money, that
money is generally deposited into
another or the same bank thus
creating more deposits and more
reserves to be lent out.
The Money Multiplier is the amount of
money that the banking system
generates with each dollar of reserves.
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The Money Multiplier
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
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The Money Multiplier
First National Bank
Second National Bank
Assets
Assets
Liabilities
Reserves
$9.00
Deposits
$90.00
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Loans
$90.00
Total Assets
$100.00
$81.00
Total Liabilities
$100.00
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Total Assets
$90.00
Total Liabilities
$90.00
The Money Multiplier
First National Bank
Second National Bank
Assets
Assets
Liabilities
Reserves
$9.00
Deposits
$90.00
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Loans
$90.00
Total Assets
$100.00
$81.00
Total Liabilities
$100.00
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Total Assets
$90.00
Total Liabilities
$90.00
The Money Multiplier
First National Bank
Second National Bank
Assets
Assets
Liabilities
Reserves
$9.00
Deposits
$90.00
Reserves
$10.00
Liabilities
Deposits
$100.00
Total Money Supply = $190.00!
Loans
Loans
$90.00
Total Assets
$100.00
$81.00
Total Liabilities
$100.00
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Total Assets
$90.00
Total Liabilities
$90.00
What determines the size of the money
multiplier?
The
money multiplier
is the reciprocal of the
reserve ratio.
1
– With a reserve
M
=
requirement (R) of 20%
R
or 1/5 . . .
– The multiplier will be 5.
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Tools of Monetary Control
The Fed has three instruments of
monetary control:
Open-Market Operations:
– Buying and selling bonds.
Changing
the Reserve Ratio:
– Increasing or decreasing the ratio.
Changing
the Discount Rate:
– The interest rate the Fed charges other
banks for loans.
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Problems in Controlling the Money
Supply
Two
problems that the Fed must
“wrestle” that arise due to fractionalreserve banking:
The Fed does not control the amount
of money that households choose to
hold as deposits in banks.
The Fed does not control the amount
of money that bankers choose to lend.
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