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© 2007 Thomson South-Western
What Money Is and Why It’s Important
• Without money, trade would require barter,
the exchange of one good or service for another.
• Every transaction would require a double coincidence of
wants – the unlikely occurrence that two people each
have a good the other wants.
• Most people would have to spend time searching for
others to trade with – a huge waste of resources.
• This searching is unnecessary with money,
the set of assets that people regularly use to buy g&s
from other people.
THE MONETARY SYSTEM
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The Functions of Money
• Money has three functions in the economy:
• Medium of exchange
• Unit of account
• Store of value
© 2007 Thomson South-Western
The Functions of Money
• Medium of Exchange
• A medium of exchange is an item that buyers give
to sellers when they want to purchase goods and
services.
• A medium of exchange is anything that is readily
acceptable as payment.
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The Functions of Money
• Unit of Account
• A unit of account is the yardstick people use to post
prices and record debts.
• Store of Value
• A store of value is an item that people can use to
transfer purchasing power from the present to the
future.
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The Functions of Money
• Liquidity is the ease with which an asset can be
converted into the economy’s medium of
exchange.
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The 2 Kinds of Money
Commodity money:
takes the form of a commodity
with intrinsic value
Examples: gold coins, cigarettes
in POW camps
Fiat money:
money without intrinsic value,
used as money because of
govt decree
Example: the U.S. dollar
THE MONETARY SYSTEM
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Money in the U.S. Economy
• Currency is the paper bills and coins in the
hands of the public.
• Demand deposits are balances in bank accounts
that depositors can access on demand by
writing a check.
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Figure 1 Two Measures of the Money Stock for the U.S.
Economy
Billions
of Dollars
M2
$6,398
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($5,035 billion)
M1
$1,363
0
• Demand deposits
• Traveler’s checks
• Other checkable deposits
($664 billion)
• Currency
($699 billion)
• Everything in M1
($1,363 billion)
© 2007 Thomson South-Western
CASE STUDY: Where Is All The Currency?
• In 2004 there was $699 billion of U.S. currency
outstanding.
• That is $3,134 in currency per adult.
• Who is holding all this currency?
• Currency held abroad
• Currency held by illegal entities
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THE FEDERAL RESERVE SYSTEM
• 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.
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THE FEDERAL RESERVE SYSTEM
• The Fed was created in 1913 after a series of
bank failures convinced Congress that the
United States needed a central bank to ensure
the health of the nation’s banking system.
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The Structure of the Fed
The Federal Reserve System
consists of:
– Board of Governors
(7 members),
located in Washington, DC
– 12 regional Fed banks,
located around the U.S.
Ben S. Bernanke
Chair of FOMC,
Feb 2006 – present
– Federal Open Market
Committee (FOMC),
includes the Bd of Govs and
presidents of some of the regional Fed banks
The FOMC decides monetary policy.
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The Fed’s Organization
• Three Primary Functions of the Fed
• Regulates banks to ensure they follow federal laws
intended to promote safe and sound banking
practices.
• Acts as a banker’s bank, making loans to banks and
as a lender of last resort.
• Conducts monetary policy by controlling the money
supply.
© 2007 Thomson South-Western
The Federal Open Market Committee
(FOMC)
• Monetary policy is conducted by the Federal
Open Market Committee.
• The money supply refers to the quantity of money
available in the economy.
• Monetary policy is the setting of the money supply
by policymakers in the central bank.
© 2007 Thomson South-Western
The Federal Open Market Committee
• Open-Market Operations
• The money supply is the quantity of money
available in the economy.
• The primary way in which the Fed changes the
money supply is through open-market operations.
• The Fed purchases and sells U.S. government bonds.
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The Federal Open Market Committee
• Open-Market Operations
• 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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BANKS AND THE MONEY SUPPLY
• Banks can influence
the quantity of
demand deposits in
the economy and the
money supply.
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BANKS AND THE MONEY SUPPLY
• Reserves are deposits that banks have received
but have not loaned out.
• In a fractional-reserve banking system, banks
hold a fraction of the money deposited as
reserves and lend out the rest.
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BANKS AND THE MONEY SUPPLY
• The reserve ratio is
the fraction of
deposits that banks
hold as reserves.
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Money Creation with Fractional-Reserve
Banking
• When a bank makes a loan from its reserves,
the money supply increases.
• 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.
• The fraction of total deposits that a bank has to keep
as reserves is called the reserve ratio.
• Loans become an asset to the bank.
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Banking Money Creation with FractionalReserve
• This T-Account
shows a bank that…
• accepts deposits,
• keeps a portion
as reserves,
• and lends out
the rest.
• It assumes a
reserve ratio
of 10%.
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
© 2007 Thomson South-Western
Money Creation with Fractional-Reserve
Banking
• When one bank loans money, that money is
generally deposited into another bank.
• This creates more deposits and more reserves to
be lent out.
• When a bank makes a loan from its reserves,
the money supply increases.
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The Money Multiplier
• How much money is eventually created by the
new deposit in this economy?
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The Money Multiplier
• The money multiplier is the amount of money
the banking system generates with each dollar
of reserves.
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The Money Multiplier
Increase in the Money Supply = $190.00!
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
© 2007 Thomson South-Western
The Money Multiplier
Original deposit = $100.00
• 1st Natl. Lending = 90.00 (=.9 x $100.00)
• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
• … and on until there are just pennies left to
lend!
• Total money created by this $100.00 deposit is
$1000.00. (= 1/.1 x $100.00)
© 2007 Thomson South-Western
The Money Multiplier
• The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
• Example:
• With a reserve requirement, R = 20% or .2:
• The money multiplier is 1/.2 = 5.
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The Fed’s Tools of Monetary Control
• The Fed has three tools in its monetary toolbox:
• Open-market operations
• Changing the reserve requirement
• Changing the discount rate
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The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.
 To increase money supply, Fed buys govt bonds,
paying with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the
money supply to expand.
 To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the process
works in reverse.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.
 OMOs are easy to conduct, and are the Fed’s
monetary policy tool of choice.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR):
affect how much money banks can create by making
loans.
 To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
 To reduce money supply, Fed raises RR,
and the process works in reverse.
 Fed rarely uses reserve requirements to control
money supply: Frequent changes would disrupt
banking.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
 When banks are running low on reserves,
they may borrow reserves from the Fed.
 To increase money supply,
Fed can lower discount rate, which encourages
banks to borrow more reserves from Fed.
 Banks can then make more loans, which increases
the money supply.
 To reduce money supply, Fed can raise discount rate.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
 The Fed uses discount lending to provide extra
liquidity when financial institutions are in trouble,
e.g. after the Oct. 1987 stock market crash.
 If no crisis, Fed rarely uses discount lending –
Fed is a “lender of last resort.”
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Federal Funds Rate
• On any given day, banks with insufficient reserves can
borrow from banks with excess reserves.
• The interest rate on these loans is the federal funds
rate.
• The FOMC uses OMOs to target the fed funds rate.
• Many interest rates are highly correlated,
so changes in the fed funds rate cause changes in other
rates and have a big impact in the economy.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Fed Funds Rate and Other Rates, 19702008
Fed funds
20
prime
3-month Tbill
15
(%)
mortgage
10
5
0
1970
1975
1980
1985
1990
1995
2000
2005
© 2007 Thomson South-Western
Monetary Policy and the Fed Funds Rate
To raise fed funds
rf
rate, Fed sells Federal
funds rate
govt bonds (OMO).
This removes
3.75%
reserves from the
banking system,
3.50%
reduces supply of
federal funds,
causes rf to rise.
The Federal
Funds market
S2
S1
D1
F2 F1
Quantity of
federal funds
THE MONETARY SYSTEM
F
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Problems Controlling the Money Supply
• If households hold more of their money as
currency, banks have fewer reserves,
make fewer loans, and money supply falls.
• If banks hold more reserves than required,
they make fewer loans, and money supply
falls.
• Yet, Fed can compensate for household
and bank behavior to retain fairly precise
control over the money supply.
THE MONETARY SYSTEM
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Bank Runs and the Money Supply
• A run on banks:
When people suspect their banks are in trouble, they
may “run” to the bank to withdraw their funds, holding
more currency and less deposits.
• Under fractional-reserve banking, banks don’t have
enough reserves to pay off ALL depositors, hence
banks may have to close.
• Also, banks may make fewer loans and hold more
reserves to satisfy depositors.
• These events increase R, reverse the process of money
creation, cause money supply to fall.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
Bank Runs and the Money Supply
• During 1929-1933, a wave of bank runs and
bank closings caused money supply to fall 28%.
• Many economists believe this contributed to the
severity of the Great Depression.
• Since then, federal deposit insurance has helped
prevent bank runs in the U.S.
• In the U.K., though, Northern Rock bank
experienced a classic bank run in 2007 and was
eventually taken over by the British govt.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
Summary
• The term money refers to assets that people
regularly use to buy goods and services.
• Money serves three functions in an economy:
as a medium of exchange, a unit of account,
and a store of value.
• Commodity money is money that has intrinsic
value.
• Fiat money is money without intrinsic value.
© 2007 Thomson South-Western
Summary
• The Federal Reserve, the central bank of the
United States, regulates the U.S. monetary
system.
• It controls the money supply through openmarket operations or by changing reserve
requirements or the discount rate.
© 2007 Thomson South-Western
Summary
• When banks loan out their deposits, they
increase the quantity of money in the economy.
• Because the Fed cannot control the amount
bankers choose to lend or the amount
households choose to deposit in banks, the
Fed’s control of the money supply is imperfect.
© 2007 Thomson South-Western