Currency: The paper money and coins owned by people and business firms

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1 WHAT IS MONEY? Things acceptable as a means of payment 2 TYPES OF MONEY 1. COMMODITY MONIES: 2. FIAT MONIES (TOKEN MONIES): DECREED BY THE GOV T AS LEGAL TENDER. The gov t promises the public that will not print paper money so fast that it loses its value. Expanding the supply of currency so rapidly that it loses much of its value has been a problem throughout history: CURRENCY DEBASEMENT. FUNCTIONS OF MONEY A UNIT OF ACCOUNT Standardized way of measuring value of things that are traded STORE OF VALUE One way in which HHs can hold their wealth A MEANS OF PAYMENT Only things that are widely acceptable as a means of payment, as a payment of debt. WHY MONEY IMPORTANT TO STUDY? MONEY is valuable to a society b/c money reduces transaction costs. This in turns leads to increased levels of mutually beneficial trade. The more complex and diverse an economic system becomes, the greater the value to society is a reliable monetary system. MEASURING THE MONEY SUPPLY Amount of money in circulation can affect macroeconomy Total amount of money held by the public o An asset is considered liquid if it can be converted to cash quickly and at little cost MEASURING THE SUPPLY OF MONEY IN THE U.S. M1: money supply economists/gov t officials speak about, standard measure of money stock all the forms of money that can be directly used for transactions = Cash of the public + DDs + Other Checking account deposits + travelers checks Currency: The paper money and coins owned by people and business firms Deposits (Demand deposits): Are balances in banks and other depository institutions that you can withdraw on demand by writing a check.

2 Other checkable deposits: include negotiated order of withdrawal (NOW) accounts at thrift institutions and share draft accounts at credit unions. Legally only commercial banks can offer checking accounts. M2 (BROAD MONEY): near monies (savings and money market account balances) = M1 + savings type accounts + retail MMMF balances + small denomination time deposits MONEY SUPPLY Consists of just two components Cash in the hands of the public and demand deposits Our definition of the money supply corresponds closely to liquid assets that our national monetary authority, the Federal Reserve, can control THE BANKING SYSTEM: FINANCIAL INTERMEDIARIES - business firms that specialize in Assembling loanable funds from HHs and firms whose revenues exceed their expenditures o Channeling those funds to HHs and firms (and sometimes the gov t) whose expenditures exceed revenues o earn a profit for providing brokering services by charging a higher interest rate on funds they lend than rate they pay to depositors THE ECONOMIC FUNCTIONS (3 ROLES) OF BANKS: BORROWERS AND LENDERS TOGETHER o Create liquidity by accepting deposits that can be withdrawn instantly and using these deposits to make long-term loans. SMALL MONEY TO LARGE MONEY o Minimize the cost of obtaining funds by pooling many people s relatively small deposits into large sums that can be loaned to many borrowers. o Then lending them to larger borrowers INFORMATION AND MONITORING o Minimize the cost of monitoring borrowers by specializing in this activity. o Pool risk by lending to many different borrowers so that if one borrower is unable to pay back the loan the lender loses only a small fraction of total deposits. COMMERCIAL BANKS ( BANKS ) A private corporation that provides services to the public Owned by its stockholders For our purposes, most important service is to provide checking accounts Enables bank s customers to pay bills and make purchases without holding large amounts of cash that could be lost or stolen Banks provide checking account services in order to earn a profit A BANK S BALANCE SHEET A balance sheet is a two-column list that provides information about financial condition of a bank at a particular point in time In one column, bank s assets are listed: Everything of value that it owns

3 On the other side, the bank s liabilities are listed: Amounts bank owes Bond: A promise to pay back borrowed funds, issued by a corporation or gov t agency Loan: An agreement to pay back borrowed funds, signed by a HH or noncorporate business Net worth = Total assets Total liabilities HOW BANKS CREATE MONEY: FRACTIONAL RESERVE BANKING - Reserves consist of deposits at Fed plus currency that is physically held by banks (called vault cash ). the required reserve ratio is that banks are required, by regulation, to keep as reserves. TOTAL RESERVES INTO TWO CATEGORIES: REQUIRED RESERVES (RR): The Fed requires banks to hold. Excess RESERVES (ER): Actual reserve - RR. Additional reserves that banks choose to hold. Banks reports level of reserves every day & must meet requirements e.g 10%. DEMAND DEPOSIT (MONEY = M1 MONEY)MULTIPLIER = 1/ RRR where RRR: required reserve ratio Money Supply = (1 / RRR) x Reserves The amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits MONETARY BASE (AKA. HIGH POWERED MONEY) Controlled by the Fed. increase in it will lead to a multiple increase in the money supply Bank reserves Currency held by the non-bank public Federal Reserve Notes: Monetary liabilities of the Fed Coins: The U.S. Treasury s monetary liabilities Monetary base can potentially support M1 in the form of deposits are about 10 times the size of the base-deposits and vault cash. CENTRAL BANK: is a bank for banks controls its money supply in a nation A nation s principal monetary authority THE FEDERAL RESERVE SYSTEM (THE FED) Is the central bank in the US Established by the Federal Reserve Act of TOOLS OF THE FED: Required Reserve Ratios Discount Rates Open Market Operations: A Federal Reserve sale or purchase of US government bonds.

4 THE STRUCTURE OF THE FED The Board of Governors 12 Federal Reserve Banks The Federal Open Market Committee BOARD OF GOVERNORS Consists of 7 members who are appointed by President of the US and confirmed by Senate for a 14-year term Sets Required reserve ratio Reviews and Determines Discount Rate Four-year term of the chair is not coterminous with four-year term of the President 12 FEDERAL RESERVE BANKS Each is supervised by 9 directors, who appoint president and other officers of the FRB o 3 are appointed by Board of Governors o 6 are elected by private commercial banks, the official stockholders of the system o a president of the bank manages its day-to-day operations Establish (FEDERAL RESERVE) DISCOUNT RATE: O the interest rate the Fed charges banks for short-term loans-the bank borrows at the Fed s discount window. THE FEDERAL OPEN MARKET COMMITTEE (FOMC) establishes U.S. monetary policy most important part of Fed Consists of 7 members of Board of Governors plus presidents of FRB of New York and four other FRBs. Open Market Operation o exerts control over nation s money supply by buying and selling bonds in public ( open ) bond market Influence monetary base Not even President of US knows details behind the decisions, or what FOMC actually discussed at its meeting, until summary of meeting is finally released MONEY SUPPLY the Fed buys or sells gov t bonds to bond dealers, banks, or other financial institutions called OPEN MARKET OPERATIONS AN OPEN MARKET PURCHASE: the Fed buys bonds, expanding the monetary base. AN OPEN MARKET SALE: the Fed sells bonds, contracting the monetary base. HOW THE FED INCREASES THE MONEY SUPPLY AN OPEN MARKET PURCHASE : LOOSER MONETARY POLICY: Fed actions that increase the growth rate of the money supply or decrease the federal funds rate AN OPEN MARKET SALE : TIGHTER MONETARY POLICY: Fed actions that reduce the growth rate of the money supply or increase the federal funds rate

5 FED S TARGET: FEDERAL FUNDS RATE: the interest rate that banks charge each other when they borrow and lend reserves for short periods. CURRENCY DRAIN: An increase in currency held outside the banks. Such a drain reduces the amount of banks reserves, thereby decreasing the amount that banks can loan and reducing the money multiplier.

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