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Macroeconomics
Econ 2301
Dr. Jacobson
Coach Stuckey
Today
Begin Chapter 14
Chapter 14
Money, Banking, and
The Federal Reserve
System
Money Facilitates
Transactions Without It
People Would Probably
Use The Barter System.
Barter
The Exchange of One
Good Or Service For
Another. Trade Depends
Upon a Double
Coincidence of Wants.
Coincidence of Wants
The Unlikely Occurrence
That Two People Have a
Good or Service That The
Other Wants.
Problem With The Barter
System Is People Have To
Arrive At A Value For Goods
or Services and They Don’t
Always Come Out To A Even
Number. i.e. A Pig Might Be
Worth 3 or 3½ Chickens.
The Meaning of Money
Some Definitions
Money
Is The Set Of Assets In The
Economy That People
Regularly Use To Buy
Goods and Services From
Other People.
Another Definition
For Money:
The Means of Payment
or Medium of Exchange
Medium of Exchange
An Item That Buyers Give
To Sellers When They
Want To Purchase Goods
and Services.
When Everyone Trusts and
Accepts Money As
Payment For Goods,
Services, And Debt; Trade
Is Facilitated.
Unit of Account
The Yardstick People Use
To Post Prices and Record
Debts. The Unit By Which
We Measure The Value of
Things.
Store of Value
An Item That People Can Use
To Transfer Purchasing Power
From The Present To The
Future. It Allows The Value to
Be Held Over Time.
In Comparison To
Stocks, Real Estate Or
Gold; Money Is
Relatively Risk Free.
Money Allows Easy and
Quick Transactions,
Unambiguous
Determination of Price,
Plus Easy Storage of Value
Over Time.
The Benefits of Money Are
Not Free. If Wealth Is Held
In Interest-Paying Assets
Rather Than Money, It
Would Yield A Higher
Interest Rate.
Liquidity
The Ease With Which An
Asset Can Be Converted
Into The Economy’s
Medium of Exchange.
Kinds of Money
Commodity Money
Money That Takes The Form
Of a Commodity With Intrinsic
Value. Intrinsic Value Means
That The Item Would Have
Value Even If It Were Not Used
As Money. (Cattle, Beads)
Intrinsic Value
of Money
The Commodity Value Of a
Piece Of Money (e.g. The
Market Value of Copper in
a Copper Coin).
Legal Tender
Money That By Law
Must Be Accepted As
Payment For Debts. All
U.S. Coins and Currency
Are Legal Tender, But
Checks Are Not.
Gold Standard
When An Economy Uses Gold
As Money (Or Uses Paper
Money That Is Convertible Into
Gold On Demand), It Is Said To
Be Operating Under The Gold
Standard.
The Gold Standard Was Used
From 1717 Until 1933. Each
Country During That Time
Fixed Its Currency In Terms Of
A Fixed Amount Of Gold.
Therefore All Countries (On
The Gold Standard) Had A
Fixed Exchange Rate Between
Their Currencies.
In 1944 Nations Gathered
At Bretton Woods, NH To
Form The Bretton Woods
Agreement. It Pegged The
Currency of Nations To
The U.S. Dollar and Gold.
In 1971, President Nixon
Severed The Link Between
Gold and The U.S. Dollar
Thus Ending The Bretton
Woods Agreement. The
U.S. Had Pegged The
Currency At $35 an Ounce.
Money Without
Intrinsic Value is
Called Fiat Money
Fiat Money
Is Money Without Intrinsic
Value That Is Used As
Money Because of
Government Decree.
Money In The U.S.
Economy; The Quantity of
Money Circulating In The
Economy Is Called The
Money Stock.
We Have Seen Where The
Federal Reserve Recently
Increased The Amount of
Currency By $100 Billion
So The Total Figure Now
Stands At Approximately
$800 Billion.
Currency
The Paper Bills and Coins
In The Hands of The
Public.
Demand Deposits
Balances In Bank
Accounts That Depositors
Can Access On Demand
By Writing a Check.
Two Measures of The
Money Stock For The
United States
Economy M1 and M2.
M1 Money (2004)
$1,363 Billion
Demand Deposits
Traveler’s Checks
Other Checkable Deposits ($664
Billion)
Currency ($699 Billion)
M2 Money (2004)
$5,035 Billion
Savings Deposits
Small time Deposits
Money Market and Mutual
Funds
A Few Minor Categories
M1 and M2 (2004)
$6,398 Billion
Important Note:
Credit Cards Are Not
Considered Either M1 or
M2 Money. They Really
Defer Payment On a
Debt.
Much Of The U.S. Currency
Is Either Held By
Foreigners or By People
Dealing in Illegal Trade
(Drugs, etc.)
Federal Reserve
System
We Have Talked A Lot
About The Actions of The
Federal Reserve Board
Now Let Us Examine Just
Who They Are and What
They Do.
Federal Reserve (Fed)
The Central Bank of The
United States.
Central Bank
An Institution Designated
To Oversee the Banking
System and Regulate The
Quantity Of Money In The
United States Economy.
Money Supply
The Quantity of Money
Available In The Economy.
Monetary Policy
The Setting of The Money
Supply By Policymakers In
The Central Bank.
Federal Reserve Board
Made Up of
Federal Reserve Board
7 Members- 14 Year Terms
Appointed By President
Confirmed By Senate.
Chairman- 4 Year Term,
Appointed by President.
Federal Reserve System
Federal Reserve Board of
Governors- 7 Members
12 Regional BanksPresidents Are Chosen By
The Board of Directors of
Each Bank.
The Fed Has Two Jobs:
1. To Regulate Banks and
Ensure The Health of The
Banking System.
2. Control the Quantity of
Money That is Made
Available in The Economy.
Monetary Policy is Made
By the Federal Open
Market Committee
(FOMC)
Federal Open Market
Committee (FOMC)
7 Members of The Board of Governors.
12 Presidents of Each of the 12
Regional Banks (Only 5 Vote, NY and
Rotating 4, However, All 12 Attend).
Meets About Every 6 Weeks. In
Washington, D.C. To Discuss The
Condition of The Economy and
Consider Changes In Monetary Policy.
The Federal Reserve System
Consists of 12 Regional Banks
New York
Richmond
Cleveland
San Francisco
Dallas
St. Louis
Chicago
Philadelphia
Atlanta
Boston
Minneapolis
Kansas City
Note:
There is Only One Bank in
The West That Services
Washington, Oregon,
Idaho, Utah, Nevada,
Arizona and California
(Located in San Francisco).
The Primary Tool of The
FED is The Purchase and
Sale of Government Bonds
If The FED Decides To Increase
The Money Supply, The FED
Creates Dollars and Uses Them
To Buy Government Bonds From
The Public In The Nation’s Bond
Market. After The Purchase
These Dollars Are In The Hands
of The Public. Thus Increasing
The Money Supply.
Likewise, If The FED Decides To
Decrease The Money Supply, The
FED Sells Government Bonds
From Its Portfolio To The Public
In The Nation’s Bond Markets.
After The Sale, The Dollars It
Receives For The Bonds Are Out
Of The Hands Of The Public.
Remember:
When The Government
Prints Too Much Money
Prices Rise.
Now Let Us Look At
Banks and The Money
Supply.
Recall That Banks Take
Individual’s Deposits
(Demand Deposits)
Either For Checking
Accounts or Savings.
First Let Us Assume That
Banks Take in Deposits But
Never Loan Any Out. For
Safety Sake, They Keep The
Money, In the Vault, In Case
People Come in and Want
Their Money (Demand
Deposits).
These Funds The Bank
Keeps In Case The
Depositors Want Them
Are Called Reserves.
Reserves
Deposits That Banks
Have Received But Have
Not Loaned Out.
In This Instance Where
Banks Are Not Loaning
Any Money Out, We Say
They Have 100% Reserve
Banking.
Looking At This As
An Accountant We
Would Have:
Bank
Assets
Reserves
$ 100.00
Liabilities
Deposits $100.00
Because The Banks Are
Holding All (100%) of The
Money In Their Vault, They
Have No Influence on The
Money Supply (The Total
Money Available In the
System).
We Know That Banks Must
Loan Out Money At A Higher
Interest, Then They Are Paying
to Depositors, To Stay In
Business. Yet, They Must
Maintain Some Reserve For
People Who Want Their
Money, So Lets Look At What
Actually Happens.
The Banks Need To Keep
Only a Fractional Amount
of The Total Amount On
Reserve And This
Fractional-Reserve Or
Reserve Ratio is Set By
The FED.
Fractional-Reserve
Banking
A Banking System In
Which Banks Hold Only A
Fraction Of Deposits As
Reserves.
Reserve Ratio
The Fraction of Deposits
That Banks Hold As
Reserves.
Reserve Requirement
The Minimum Amount of
Reserves, Set By The
Federal Reserve, That A
Bank Must Hold.
Excess Reserves
An Amount Held By
Banks Above The Legal
Minimum.
Now Let Us Say That The
Federal Reserve (FED)
Requires A 10% Reserve
An The Banks Loan Out
The Balance. What Will
Our T-Account Look Like?
Bank
Assets
Reserves
Loans
Liabilities
$ 10.00
90.00
Deposits $100.00
But What Now Happened
To The Money Supply?
The Depositors Still Have
Demands Totaling $100,
But Now Borrowers Have
$90 in Currency.
The Money Supply Has
Now Increased To $190.
Therefore, When Banks
Hold Only a Fraction of The
Deposits In Reserve,
Banks Create Money.
Now Let Us Look
Closer At The
Multiplier Effect Or
The Money Multiplier.
Money Multiplier
The Amount Of Money The
Banking System Generates
With Each Dollar Of
Reserves.
Book Example:
Uses Three Banks Where Each
Person Who Makes a Loan
With The Bank Gives The
Money To Someone Who
Deposits It In Another Bank
and So On For Three Banks.
Bank #1
Assets
Reserves
Loans
Liabilities
$ 10.00
90.00
Deposits $100.00
Bank
#2
Assets
Reserves
Loans
$ 9.00
81.00
Liabilities
Deposits $90.00
Bank #3
Assets
Reserves
Loans
$ 8.10
72.90
Liabilities
Deposits $81.00
Total Multiplier
Original Deposit
1st Bank
2nd Bank
3rd Bank
4th – 10th Bank
=
=
=
=
$100.00
90.00 = .9 X $100.00
81.00 = .9 X $90.00
72.90 = .9 X $81.00
Total Money Supply = $1,000
The Higher The Reserve
Ratio, The Less of Each
Deposit Banks Loan
Out, and The Smaller
The Money Multiplier.
The FED Has 3 Tools to
Use For Monetary
Control
1. Open-Market Operations.
2. Reserve Requirements.
3. The Discount Rate.
#1 Open-Market
Operations
The Purchase and Sale Of
U.S. Government Bonds By
The FED.
To Increase The Money Supply
The FED Instructs The N.Y.
FED To Buy Bonds From The
Public In The Nations Bond
Markets. The Dollars Paid By
The FED, Pays For The Bonds
and Increases The Number of
Dollars in The Economy.
Some of These New
Dollars Are Held as
Currency and Some Are
Deposited In Banks. Those
Deposited in Banks Go
Through The Multiplier
Effect.
To Reduce The Money Supply
The Fed Does Just The Opposite:
It Sells Bonds To The Public in
The Nations Bond Markets. The
Public Pays For These With
Currency and Bank Deposits.
This Reduces The Amount of
Money in Circulation.
#2 Reserve
Requirements
Regulations On The
Minimum Amount of
Reserves That Banks Must
Hold Against Deposits.
Reserve Ratios Influence
How Much Money The
Banking System Can
Create With Each Dollar of
Reserves.
An Increase In Reserve
Requirements Means Banks
Must Hold More In Reserve
and Therefore Can Loan Out
Less, Reducing The Multiplier
Effect and Reducing The
Money Supply.
A Decrease In Reserve
Requirements Lowers The
Reserve Ratio and Therefore
Banks Can Loan Out More,
Increasing The Multiplier
Effect and Increasing The
Money Supply.
Because of The Severe and
Immediate Effect This Has
On Banks and The Entire
System, Changes In The
Reserve Requirement Are
Rare.
#3 The Discount Rate
The Interest Rate On The
Loans That The FED Makes
To Banks.
If A Bank Has Too Few
Reserves, It Must Then Borrow
From The FED In Order To
Maintain The Reserve
Requirement. This Means
That The Banking System Has
Additional Reserves and
Allows The Banking System
To Create More Money.
By Changing The
Discount Rate The FED
Can Either Increase of
Decrease The Money
Supply.
A Higher Discount Rate:
Discourages Banks From
Borrowing Reserves.
Thereby, Reducing The
Quantity Of Reserves In The
Banking System, Which In
Turn Reduces The Money
Supply.
A Lower Discount Rate:
Encourages Banks To
Borrow From The FED,
Which Increases The
Reserves and Leads To An
Increase In The Money
Supply.
Note:
The FED Can Also Use Discount
Lending To Either Bail Out or To
Shore Up The Banking System.
Through This Mechanism It Can
Also Assist Foreign Countries
and Foreign Banks.
In The Fractional-Reserve
Banking System, The Amount
of Money In The Economy and
The Money Supply Depend On
Two Items: The Behavior of
Depositors (People Saving)
and The Amount of Reserves
The Banks Choose To Keep.
Problems For The
FED
If People Choose To Save
(Deposit Funds With The
Banking System) Then The
Banks Have More Money
To Loan Out and The
Money Supply Increases.
However, If People Choose
Not To Save Then The
Banks Don’t Have The
Deposits From Which To
Make Loans and The
Money Supply Is
Decreased.
Remember Our National
Savings Rate and What It
Has Been Doing?
If Banks Choose To Keep a
Higher or Lower Reserve
On Hand Than is Required
Then The Money Supply Is
Either Reduced or
Expanded.
Questions
?
Quick Write
Because of The Recent
Actions By The FED,
Would You Expect To
Happen To The U.S.
Economy Long and Short
Term and Why?