THE MEANING OF MONEY. The Functions of Money. Money has three functions in the economy: The Functions of Money. The Functions of Money

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1 In this chapter, look for the answers to these questions: What assets are considered money? What are the functions of money? The types of money? 11 What is the Federal Reserve? What role do banks play in the monetary system? How do banks create money? How does the Federal Reserve control the money supply? THE MEANING OF MONEY Money is the set of assets in an economy that people regularly use to buy goods and services from other people. 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 Functions of Money Money has three functions in the economy: Medium of exchange Unit of account Store of value 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. 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. The Functions of Money Liquidity is the ease with which an asset can be converted into the economy s medium of exchange. 1

2 The Kinds of Money Commodity money takes the form of a commodity with intrinsic value. Examples: Gold, silver, cigarettes. Fiat money is used as money because of government decree. It does not have intrinsic value. Examples: Coins, currency, check deposits. 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. Figure 1 Two Measures of the Money Stock for the U.S. Economy Billions of Dollars $6,398 $1,363 0 M1 Demand deposits Traveler s checks Other checkable deposits ($664 billion) Currency ($699 billion) M2 Savings deposits Small time deposits Money market mutual funds A few minor categories ($5,035 billion) Everything in M1 ($1,363 billion) 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 Central Banks & Monetary Policy Central bank: an institution that oversees the banking system and regulates the money supply Monetary policy: the setting of the money supply by policymakers in the central bank Federal Reserve (Fed): the central bank of the U.S. 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. 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. 2

3 THE FEDERAL RESERVE SYSTEM The primary elements in the Federal Reserve System are: The Board of Governors The Regional Federal Reserve Banks The Federal Open Market Committee The Fed s Organization The Fed is run by a Board of Governors, which has seven members appointed by the president and confirmed by the Senate. Among the seven members, the most important is the chairman. The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees. The Board of Governors Serve staggered 14-year terms so that one comes vacant every two years. President appoints a member as chairman to serve a four-year term. The Fed s Organization The Federal Reserve System The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks. The Federal Reserve Banks Twelve district banks Nine directors Three appointed by the Board of Governors. Six are elected by the commercial banks in the district. The directors appoint the district president, which is approved by the Board of Governors. The New York Fed implements some of the Fed s most important policy decisions. 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. The Federal Open Market Committee (FOMC) Serves as the main policy-making organ of the Federal Reserve System. Meets approximately every six weeks to review the economy. The Federal Open Market Committee (FOMC) is made up of the following voting members: The chairman and the other six members of the Board of Governors. The president of the Federal Reserve Bank of New York. The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis). 3

4 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. 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. 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. BANKS AND THE MONEY SUPPLY Banks can influence the quantity of demand deposits in the economy 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. The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. Banks may hold more than this minimum amount if they choose. The reserve ratio is the fraction of deposits that banks hold as reserves. 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. Banking Money Creation with Fractional- Reserve Money Creation with Fractional-Reserve Banking T-account: a simplified accounting statement that shows a bank s assets & liabilities. Banks liabilities include deposits, assets include loans & reserves. 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 Loans Total Assets Liabilities Deposits Total Liabilities 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. 4

5 The Money Multiplier How much money is eventually created by the new deposit in this economy? The money multiplier is the amount of money the banking system generates with each dollar of reserves. The Money Multiplier Increase in the Money Supply = $190.00! First National Bank Assets Reserves $10.00 Liabilities Deposits Second National Bank Assets Reserves $9.00 Liabilities Deposits Loans Total Assets Total Liabilities Loans $81.00 Total Assets Total Liabilities The Money Multiplier Original deposit = 1st Natl. Lending = (=.9 x ) 2nd Natl. Lending = (=.9 x $ 90.00) 3rd Natl. Lending = (=.9 x $ 81.00) and on until there are just pennies left to lend! Total money created by this deposit is $ (= 1/.1 x ) 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. Exercise Exercise While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Fed s reserve requirement is 20% of deposits. A. What is the maximum amount that the money supply could increase? B. What is the minimum amount that the money supply could increase? 28 You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase? If banks hold no excess reserves, then money multiplier = 1/R = 1/0.2 = 5 The maximum possible increase in deposits is 5 x $50 = $250 But money supply also includes currency, which falls by $50. Hence, max increase in money supply = $200. B. What is the minimum amount that the money supply could increase? Answer: $0 If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply remains unchanged. 29 5

6 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 The Fed s Tools of Monetary Control Open-Market Operations The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: When the Fed sells government bonds, the money supply decreases. Fed sells govt bonds, taking dollars out of circulation which are withdrawn from banks, reducing reserves banks have to ask borrowers to repay their loans, and as the volume of loans decreases, money supply decreases. When the Fed buys government bonds, the money supply increases. 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. The Fed s Tools of Monetary Control Reserve Requirements The Fed also influences the money supply with reserve requirements. Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. Changing the Reserve Requirement The reserve requirement is the amount (%) of a bank s total reserves that may not be loaned out. Increasing the reserve requirement decreases the money supply. Fed raises RR, Banks make fewer loans from each dollar of reserves, which decreases money multiplier and money supply. Decreasing the reserve requirement increases the money supply. To increase money supply, Fed reduces RR. Banks make more loans from each dollar of reserves, which increases money multiplier and money supply. Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking. The Fed s Tools of Monetary Control Changing the Discount Rate 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. 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. Problems in Controlling 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. The Fed does not control the amount of money that households choose to hold as deposits in banks. The Fed does not control the amount of money that bankers choose to lend. 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 & hold more reserves to satisfy depositors. These events increase R, reverse the process of money creation, cause money supply to fall. During , 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. Bank runs not a problem today due to federal deposit insurance. 6