© 2007 thomson south-western. the monetary system 1 what money is and why it’s important without...


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.


The Functions of Money

• Money has three functions in the economy:• Medium of exchange• Unit of account• Store of value



• 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.



• Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.



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


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

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


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


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 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.


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


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)

• 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.


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.


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 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

• 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


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.


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.



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


Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00




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)



• 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.


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 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.



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.



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.



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.



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.”



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 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



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



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.



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.



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


• 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


• 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


• 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. the monetary system 1 what money is and why it’s important without...

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