Download CHAPTER 31: MONEY AND BANKING Introduction - jb

CHAPTER 31: MONEY AND BANKING
Introduction
While fiscal policy is central to economic stabilization, government officials have a second set of
stabilization tools in monetary policy. Money is essential for a modem economy, facilitating the
movement of goods and services through the circular flow and serving as the incentive for
entrepreneurs and workers. Chapter 31 begins a three-chapter exploration of the role of money in
the economy, describing the function s and definitions of money and the structure of the Federal
Reserve System. An understanding of these functions and structures paves the way for
exploration of how the Federal Reserve uses money to stabilize the economy. Material from
Chapter 31 may appear in one or two multiple-choice questions on the AP macroeconomics
exam.
The Functions of Money
Money serves three purposes. First, it is a medium of exchange, which means it is used for
buying goods and services. It is very difficult, if not impossible, for barter to work in an
economy as large as that of the United States. Money facilitates exchange, making the process
more efficient. Second, money is a unit of account, making it easier to determine the relative
values of goods. Rather than having to remember that eight tomatoes equals one gallon of gas
and fifteen gallons of gas equals one sweater, monetary amounts make comparison easier.
Finally, money serves as a store of value. You can save money over time and use it for future
purchases.
Money is perfectly liquid, meaning it can he spent instantly . Other investments, such as stock or
baseball cards or homes, are more illiquid, because it takes time to sell the asset and convert it to
cash . Stock can be sold fairly quickly to get spendable money, while it may take weeks or
months to sell a home. Liquidity is important, because aggregate demand depends on the ability
to purchase goods and services.
Definitions of Money
In general, money is anything that is widely accepted by buyers and sellers as a medium of
exchange. However, money can take a variety of fonns , including bills, coins, animal teeth,
precious metals, or crops- anything buyers and sellers accept. Commodity money is money that
has intrinsic value, such as gold coins, com, or tobacco; it can be used for another purpose and
has value for that purpose. Fiat money (or token money) is money that only has value because
society accepts that it has value. Federal Reserve Notes used in the United States state "This note
is legal tender for all debts, public and private." Fiat money is the common form of currency
used in the United States and the world today.
MI is the most commonly used measure of the money supply. M! consists of currency (paper
money and coins) and demand deposits (checking accounts, including travelers' checks and debit
cards which directly draw from your bank account to make purchases). Today, most ofM!
consists of currency, but checks can be preferable for transferring large amounts of money owing
to their safety and the creation of a receipt when the check is cashed. M! is perfectly liquid
money that can be instantly spent.
220
Chapter 31 : Money and Banking
Chapter 31: Money and Banking
Bear in Mind
For ~ecad~s, demand deposits were a larger proportion of M 1 than currency was. In 2002, the
relat.lOnshlp reversed, since M 1 now consists of currency more than checkable deposits. Older
versIOns of the AP macroeconomics exam refer to the proportions as they existed at that time.
Taking the EEK! Out of Economics
You may have noticed that credit cards, another method of apparently instant payment for goods
and services, are not included in the money supply. This is because purchases via credit cards are
not money; they are short-term loans from the institution that issued the credit card. The bank
makes the payment at the time of purchase, and at the end of the month, you must pay the credit
card bill with currency or a check.
M2 is a broader definition of money, including the currency and demand deposits ofMl plus the
"near-money" of savings deposits, certificates of deposit (CDs) ofless than $100,000, and money
market mutual funds. "Near money" is fairly liquid but requires a withdrawal to convert it to
cash or a demand deposit.
The Value of Money
Because U.S. currency is fiat money, it has no intrinsic value. As late as the early 20th century,
American dollars were "backed" by gold, meaning dollars could be traded in at a financial
institution for a specific amount of gold per dollar. This backing was designed to inspire
consumer confidence in the value of currency. However, tying the money supply to a precious
metal left the money supply susceptible to wide swings in the gold supply. Economists today
agree that it is better to be able to change the money supply to meet the needs of the economy.
Therefore, the money supply today is not backed, and the money supply is controlled by the
Federal Reserve System.
Three things help money to maintain its value today: acceptability, designation as legal tender,
and relative scarcity. As long as buyers and sellers accept that a dollar is worth a dollar, that
money has value. The government's declaration that money has value, as noted on dollar bills,
gives people confidence of that value. The Federal Reserve controls the supply of money in the
economy, limiting its availability in order to ensure that it keeps its value.
The purchasing power of money is the amount of goods and services that a specific amount of
money will buy. As the consumer price index rises during periods of inflation, the value of the
dollar falls, because the same dollars cannot stretch to buy as many products as they could before
the inflation. During deflation, the value of the dollar rises and consumers can afford to buy more
than before. In order to keep inflation in check, Congress and the president can use fiscal policy
while the Federal Reserve can use monetary policy to control the money supply and interest rates
on credit.
Chapter 31: Money and Banking
221
The Federal Reserve System
I
Board of Governors
~
Federal Open Market Commjtt~
J
t
J
I
!
12 Fedcr<ll Reserve Banks
j
1_____________
~
Commerc ial banks
--,,
Thrift InstiCutions
(savings jl;nd 10;ln associ,mons ,
mutual savings banks. cred it unions)
The public
(households and
~---
bu~jncsses)
Framework of the Federal Reserve System and its relationship to the public
The Federal Reserve System, also known as "The Fed," is the central banking system for the
United States. It controls the country's money supply and monetary policy. The Fed was created
in 1913 to address banking crises, runs on banks, and the lack of confidence in the banking
system that seriously affected economic performance.
The Board of Governors consists of seven members who are appointed by the president and
confirmed by the Senate. Members cannot be fired by the president and serve a non-renewable
fourteen-year term in order to insulate the Fed from political pressure. There is significant
political pressure to keep interest rates low, in order for consumers to be able to afford to buy
homes and cars and for firms to be able to invest in capital. However, increasing the money
supply too far can result in inflation. For this reason, the Fed was developed as an independent
agency of government. The primary role of the Board of Governors is to control the money
supply and run the Federal Reserve System.
The twelve regional Federal Reserve banks throughout the United States serve as "bankers'
banks," performing the same functions for banks that your local bank performs for you as a
customer. Regional banks allow member banks to deposit cash on account as well as provide
loans to member banks. These regional banks implement monetary policy as determined by the
Board of Governors. Regional banks are a unique hybrid of private ownership and public control,
because the regional banks are actually owned by the member banks of each district, but public
officials control the banking system and its policies.
The Federal Open Market Committee (FOMC) consists of the seven members of the Board of
Governors, the president of the New York Federal Reserve Bank, and four other regional bank
presidents who serve on a rotating basis. The role of the FOMC is to conduct open market
operations, or buying and selling government securities (Treasury bonds, bills, and notes) in the
market in order to control the money supply and interest rates. Because these open market
operations are performed through the New York Federal Reserve, that bank's president is a
constant member of the committee.
Member banks consist of the many kinds of financial institutions customers use. While credit
unions and savings and loans are regulated by different agencies outside of the Federal Reserve,
222
Chapter 31: Money and Banking
Chapter 31: Money and Banking
they are still subject to the same reserve requirements and monetary controls of the Federal
Reserve.
Functions of the Federal Reserve
Federal Reserve banks are responsible for a number of functions. They issue new currency and
destroy currency that is damaged or worn out. They also set reserve requirements, such as
requiring banks to hold a certain percentage of their deposits in cash that cannot be loaned out.
Federal Reserve banks loan member banks money that must be repaid with interest, which is
known as the discount rate. Reserve banks also supervise bank operations, clear checks through
the system, and serve as the official bank of the federal government. But the most important role
of the Fed is to control the money supply and interest rates.
Multiple-Choice Questions
1.
Which of the following is a function of money?
I.
A medium of exchange
II.
A store of value
III.
A unit of account
(A)
I only
III only
(B)
(C)
I and II only
(D)
II and III only
(E)
I, II, and III
2.
The kind of currency used in the United States today can be best described as
(A)
fiat money.
(B)
intrinsic money.
(C)
commodity money.
(D)
state money.
(E)
federal commodity notes.
3.
The largest component of the Ml money supply is
demand deposits.
(B)
travelers' checks.
(C)
currency.
(D)
government bonds.
(E)
savings accounts.
(A)
4.
U.S. dollars today are backed by
(A)
gold.
(B)
silver.
(C)
government bonds.
(D)
oil.
(E)
nothing.
5.
The value of money is stabilized primarily by
(A)
controlling the gold supply.
(B)
reducing government deficits.
(C)
increasing taxes.
(D)
controlling the money supply.
(E)
reducing interest rates.
Chapter 31 : Money and Banking
223
6.
During a period of inflation,
(A)
the purchasing power of money increases by the same rate as inflation.
(B)
the purchasing power of money decreases.
(C)
the purchasing power of money remains the same.
(D)
the change in purchasing power depends on the level of unemployment.
(E)
purchasing power is based on the level of national debt.
7.
Open market operations consist of
(A)
the Fed buying and selling stock on the open market.
(B)
corporations selling stock on the open market.
(C)
firms selling products to consumers on the open market.
(D)
the Fed buying and selling government bonds on the open market.
(E)
firms trading imports and exports on the international open market.
8.
The primary role of the Federal Reserve is to
(A)
control the money supply.
(B)
process checks.
(C)
make loans to member banks.
(D)
issue new currency.
(E)
use fiscal policy to stabilize the economy.
Multiple-Choice Explanations
I.
(E)
Money serves all three functions: facilitating exchange, allowing saving, and
providing a means to compare values of products.
2.
(A)
Fiat money is money that has no intrinsic value to be used for anything other than
currency.
3.
(C)
Currency now comprises more than half of the MI money supply.
4.
(E)
US currency is no longer backed by gold so that the Federal Reserve can change
the money supply to address issues of economic instability.
5.
(D)
By limiting the supply of money in the economy, the Federal Reserve helps
money maintains its value.
6.
(B)
Inflation reduces the purchasing power of the dollar, because it takes more
dollars to obtain the same amount of goods and services.
7.
(D)
The Federal Reserve buys and sells government bonds in order to change the
money supply.
8.
(A)
The Federal Reserve uses the money supply to stabilize the value of money and
affect aggregate demand through monetary policy. While the Fed does process checks,
make loans to member banks, and issue new currency, its primary role is to control the
money supply. Fiscal policy is carried out by Congress.
224
Chapter 31: Money and Banking