Download Unit VI - Amazon S3

Unit VI















The Meaning of Money
o Money is the set of assets in an economy that people regularly use to buy
goods and services from other people
Functions of Money
o Money has three functions in the economy:
 Medium of exchange
 Unit of account
 Store of value
Medium of exchange
o A medium of exchange is an item that buyers give to sellers when they want
to purchase goods and services
o A medium of exchange is anything that is readily acceptable as payment
Unit of Account
o A unit of account is the yardstick people use to post prices and record debt
Store of value
o A store of value is an item that people can use to transfer purchasing power
from the present to the future
Liquidity is the ease with which an asset can be converted into the economy’s
medium of exchange
Commodity money takes the form of commodity with intrinsic value
o Example: Gold, silver, cigarettes
Fiat money is used as money because of government decree
o It does not have intrinsic value
o Examples: Coins, currency, check deposits
Currency is the paper bills and coins in the hands of the public
Demand deposits are balances in bank accounts that can be accessed on demand by
writing a check (or using a debit card)
M1
o Demand deposits
o Traveler’s checks
o Other checkable deposits
M2 (everything in M1 is also in M2)
o Savings deposits
o Small time deposits
o money market mutual funds
In 2004, there was $699 billion of U.S. currency unaccounted for
o That is $3,134 in currency per adult
Who is holding all this currency?
o Currency held abroad
o Currency held by illegal entities
The Federal Reserve System
o The Federal Reserve (Fed) serves as the nation’s central bank
 It is designed to oversee the banking system
 It regulates the quantity of money in the economy










The Fed was created in 1913 after a series of bank failures convinced Congress that
the U.S. needed a central bank to ensure the health of the nation’s banking system
The primary elements in the Federal Reserve System are:
o The Board of Governors
o The Regional Federal Reserve Banks
o The Federal Open Market Committee
The Fed Organization
o Run by Board of Governors (members appointed by president/confirmed by
Senate)
 Staggered 14-year terms
 Chairman serves four-year terms
o Among the seven members, the most important is the chairman
 Directs the Fed staff
 Presides over board meetings
 Testifies about policy in front of Congress
The Federal Reserve System
o Federal Reserve Board in Washington D.C.
o Twelve regional Federal Reserve Banks
The Regional Reserve Banks
o Twelve districts
o Nine directors
o Directors appoint district president
o The New York Fed implements monetary policy
Three Primary functions of the Fed
o Ensures banks (deposit institutions) follow federal laws intended to promote
sound practices
o Lender of last resort: acts as a banker’s bank making loans to banks
o Controls the money supply
The Federal Open Market Committee
o Serves as the main policy-making organ of the Federal Reserve System
o Meets approximately every six weeks to review the economy
Monetary policy is conducted by the Federal Open Market Committee
o Money supply refers to the quantity of money available in the economy
o Monetary policy is the buying and selling of bonds in order to set the money
supply
 To increase money supply, Fed buys government bonds from public
 To decrease the money supply, Fed sells government bonds to the
public
Banks and the money supply
o Banks can influence the quantity of Demand Deposits in the economy and
money supply
o Reserves are deposits that banks have received but have not loaned out
o In a fractional-reserve banking system, banks hold a fraction of the money
deposited as reserves and lend out the reset
o The reserve ration is the fraction of deposits that banks hold as reserves
Money Creation with Fractional-Reserve Banking







o When a bank makes a loan from its reserves, the money supply increases
o The money supply is affected by the amount deposited in banks and the
amount that banks loan
 Deposits into a bank are recorded as both assets and liabilities
 Loans become an asset to the bank
Banking Money Creation with Fractional-Reserve
o When one bank loans money, that money is generally deposited into another
bank
o This creates more deposits and more reserves to be lent out
o When a bank makes a loan from its reserves, the money supply increases
o The money multiplier is the amount of money the banking system generates
with each dollar of reserves
The Money Multiplier
o The money multiplier is the reciprocal of the reserve ration:
 M = 1/R
o Example:
 With a reserve requirement, R=20% or .2
 The money multiplier is 1/.2 = 5
The Fed has three tools in its monetary toolbox
o Open-market operations
o Changing the reserve requirement
o Changing the discount rate
Changing the Discount Rate
o The discount rate is the interest rate the Fed charges banks for loans
 Increasing the discount rate decreases the money supply
 Decreasing the discount rate increases the money supply
The Fed’s control of the money supply is not precise
The Fed must wrestle with two problems that arise due to fractional-reserve banking
o The Fed does not control the amount of money that households choose to hold
as deposits in banks
o The Fed does not control the amount of money that bankers choose to lend
When the FOMC buys or sells bonds it is influencing the federal funds rate
o Buying bonds will increase the reserves