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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.