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© 2007 Thomson South-Western
© 2007 Thomson South-Western
THE MONETARY SYSTEM 2
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
The Functions of Money
• Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.
© 2007 Thomson South-Western
THE MONETARY SYSTEM 7
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
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
Figure 1 Two Measures of the Money Stock for the U.S. Economy
Billionsof Dollars
• Currency($699 billion)
• Demand deposits• Traveler’s checks• Other checkable deposits ($664 billion)
• Everything in M1($1,363 billion)
• Savings deposits• Small time deposits• Money market mutual funds• A few minor categories ($5,035 billion)
0
M1$1,363
M2$6,398
© 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
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
The Structure of the FedThe Federal Reserve System consists of:
– Board of Governors (7 members), located in Washington, DC
– 12 regional Fed banks, located around the U.S.
– Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy.
Ben S. BernankeChair of FOMC,
Feb 2006 – present
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
BANKS AND THE MONEY SUPPLY
• Banks can influence the quantity of demand deposits in the economy and the money supply.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
BANKS AND THE MONEY SUPPLY
• The reserve ratio is the fraction of deposits that banks hold as reserves.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
Banking Money Creation with Fractional-Reserve
• 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%.
Assets Liabilities
First National Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
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.
© 2007 Thomson South-Western
The Money Multiplier
• How much money is eventually created by the new deposit in this economy?
© 2007 Thomson South-Western
The Money Multiplier
• The money multiplier is the amount of money the banking system generates with each dollar of reserves.
© 2007 Thomson South-Western
The Money Multiplier
Increase in the Money Supply = $190.00!
Assets Liabilities
First National Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
Assets Liabilities
Second National Bank
Reserves$9.00
Loans$81.00
Deposits$90.00
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.
© 2007 Thomson South-Western
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
© 2007 Thomson South-Western
THE MONETARY SYSTEM 30
The Fed’s 3 Tools of Monetary Control1. 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.
© 2007 Thomson South-Western
THE MONETARY SYSTEM 31
The Fed’s 3 Tools of Monetary Control1. 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.
© 2007 Thomson South-Western
THE MONETARY SYSTEM 32
The Fed’s 3 Tools of Monetary Control2. 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.
© 2007 Thomson South-Western
THE MONETARY SYSTEM 33
The Fed’s 3 Tools of Monetary Control3. 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.
© 2007 Thomson South-Western
THE MONETARY SYSTEM 34
The Fed’s 3 Tools of Monetary Control3. 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.”
© 2007 Thomson South-Western
THE MONETARY SYSTEM 35
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.
© 2007 Thomson South-Western
The Fed Funds Rate and Other Rates, 1970-2008
(%)
0
5
10
15
20
1970 1975 1980 1985 1990 1995 2000 2005
Fed funds
prime
3-month Tbill
mortgage
© 2007 Thomson South-Western
THE MONETARY SYSTEM 37
Monetary Policy and the Fed Funds Rate
To raise fed funds rate, Fed sells govt bonds (OMO).
This removes reserves from the banking system, reduces supply of federal funds,
causes rf to rise.
rf
FD1
S2
3.75%
F2
S1
F1
3.50%
The Federal Funds marketFederal
funds rate
Quantity of federal funds
© 2007 Thomson South-Western
THE MONETARY SYSTEM 38
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.
© 2007 Thomson South-Western
THE MONETARY SYSTEM 39
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.
© 2007 Thomson South-Western
THE MONETARY SYSTEM 40
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.
Summary
© 2007 Thomson South-Western
• 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.
Summary
© 2007 Thomson South-Western
• The Federal Reserve, the central bank of the United States, regulates the U.S. monetary system.
• It controls the money supply through open-market operations or by changing reserve requirements or the discount rate.
Summary
© 2007 Thomson South-Western
• 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.