Download Bank - University of Wyoming

Lecture 10:
The Monetary System
Rob Godby
University of Wyoming
The Meaning of Money
Q
Q
Money is the term used to
describe the set of assets in the
economy that people regularly
use to buy goods and services
from other people.
Generally money is used to
support transactions in the
modern economy
Three Functions of
Money
{ Medium of Exchange: anything
that is readily acceptable as
payment in transactions.
| Unit of Account: serves as a
“yardstick” to help us compare the
relative values of goods.
} Store of Value: a means of
keeping some of our wealth in a
readily spendable form for future
needs.
The Two Types of
Money
Q
Commodity Money: something that
performs the function of money but
has alternative, non-monetary
uses.
X Examples: Gold, silver, cigarettes
Q
Fiat Money: something that serves
as money but has no other
important uses.
X Examples: Paper currency, check
deposits (that bear no interest)
Requirements of any Good
used as Money
QWhatever
money good is
chosen in an economy, it
must be able to fulfill the
functions of required of
money.
-ice does not make a good money as it
does not store value well
Requirements of any Good
used as Money
Q
Everyone must believe
everyone else will accept
money for transactions or else
the money good ceases to be
a money good.
XThis is especially true for fiat
money as it has no alternative
uses
Evolution of Money
Q
Q
Money was developed to avoid the
“transactions costs” incurred in a
barter economy
Transaction costs are costs
incurred to make a trade and
include time to search for someone
who wants what you have and has
what you want (the “double
coincidence of wants” required in
barter)
Evolution of Money
Q
Q
Initially, commodity money was used
in most economies, or money that
was convertible to a commodity (i.e.
gold)
After W.W. II, to anchor the world
financial system, the U.S. dollar was
chosen as a reference currency.
X All other currencies traded at a fixed
exchange rate with the U.S. dollar.
X This was called the Bretton Woods
agreement.
Evolution of Money
Q
Q
Q
Since in the U.S. this paper money
was convertible to gold (the Gold
Standard), so too were all other
currencies indirectly.
The fixed exchange rate system
was replaced by market determined
exchange rates in the 1970’s.
Eventually fiat money replaced
commodity money when Nixon
cancelled the convertibility of the
U.S. dollar.
Where is All The
Currency in the U.S.?
Q
Q
Q
In 1996 there was about $380 billion
of U.S. currency ($1,900 in currency
per person) printed.
Recall avg. GDP/person is $28,000.
Location of outstanding currency
may include:
X Currency held by firms and
households for transaction purposes
X Currency held abroad
X Currency held by illegal entities
Measuring the Money in
the U.S. Economy
Q
Q
To measure the amount of money
in the economy, one must consider
which monetary assets to include.
Different ways of measuring the
money stock in the economy:
examples:
X
X
M1
M2
Measurement of Money
Q
Q
Q
Money Stock is the quantity of
money assets in the economy.
This may include more than
actual currency in circulation (C)
The most widely cited measure
of money used (M1) includes:
X Coins
X Currency
X Check Deposits
X Travelers Checks
M1
Measurement of Money
Q
A broader measure of money than M1, is:
X M1 +
X Savings Deposits +
X Small Time Deposits +
X Money Market Mutual Funds +
X and other minor categories
M2
Who Controls the Money
Supply: The Role of the Fed
Q
Q
The Federal Reserve (“The 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 Fed’s Organization
Q
The Fed is run by its Board of
Governors.
X Seven members appointed by the
President of the United States.
X The Chairman of the Board is the
most important position: presiding,
directing, and testifying about Fed
policy. She/He is appointed by the
President.
The Fed’s Organization
Q
Q
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.
Three Primary Functions of the Fed
{ Regulation: The private banking industry must
follow federal laws intended to promote sound
banking practices, ensuring the financial system
does not break down.
| Act as a banker’s bank, making loans to other
banks as a “lender of last resort”. If banks require
funds on a short term basis to cover withdrawals
they can borrow money for a short time only
paying interest set by the “discount rate”.
} Control of the supply of money i.e. Monetary
Policy.
Money Supply Changes by the Fed
Q
Open-Market Operations: The primary
way the Fed changes the money
supply: purchase and sale of U.S.
government bonds (T-bills) with newly
printed money. The Fed also sets the
interest rate on these bonds.
X To increase the money supply, the
Fed buys government bonds from the
public, paying them new money.
X To decrease the money supply, the
Fed sells government bonds to the
public, collecting people’s money in
exchange for the bonds.
Banks and The Money
Supply
Q
Q
The behaviour of banks can
influence the quantity of demand
deposits in the economy and
therefore, the money supply (recall
M1 includes the amount of money
in such deposits.
Fractional Reserve Banking
System: The practice of holding a
fraction of money deposited as
reserves and lending out the rest.
Fractional Reserve
Banking
Q
Q
Q
Q
Deposits in a bank are recorded as
both assets and liabilities.
Deposits that have been received
but not lent out are called reserves.
The money supply in the economy
is affected by the amount of
reserves and the amount that is
lent out.
Loans become an asset to the
bank.
Bank “T-Account” Example
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
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
Total Liabilities
$100.00
A “T-Account” (not to
be confused with Tbills) 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
Q
Q
When a bank makes a loan the
money supply increases due to the
assets included in the
measurement of money. 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.
The Money Multiplier
Q
Q
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.
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
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
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
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 = $271.00!
Loans
Loans
$90.00
Total Assets
$100.00
$81.00
Total Liabilities
$100.00
Total Assets
$90.00
Total Liabilities
$90.00
What determines the size of the
money multiplier?
Q
The money multiplier is the reciprocal of the
reserve ratio.
X With a reserve requirement (R) of 10% or 1/10 .
..
X The process just of deposits, loans and deposits
just described will continue...
X The multiplier will be 10.
1
M=
R
Problems in Controlling
the Money Supply
Two problems that the Fed must
“wrestle” that arise due to
fractional-reserve 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.
Q
Tools of Monetary Control
The Fed has three instruments of
monetary control:
Q Open-Market Operations:
X Buying and selling bonds.
Q
Changing the Reserve Ratio (R):
X Increasing or decreasing the ratio.
Q
Changing the Discount Rate:
X The interest rate the Fed charges
other banks for loans. The higher
the rate, the more banks want to
avoid borrowing and the more they
hold in reserve above R
Summary
Q
Q
Q
Q
Q
Q
Money fulfills three functions : store of value, medium of
exchange and unit of account.
Two types of money: commodity and fiat.
The money supply is measured in a variety of ways
depending on what is included as money.
The Federal Reserve is the bank’s bank, regulating the
financial system, controlling the money supply and making
loans to private banks.
Money supply is controlled by open market operations,
regulating the reserves private banks must hold, and by
setting the discount rate.
The money multiplier describes how private banks can
affect the money supply by lending out their deposits.