Chapter 2

The United States Monetary The United States Monetary SystemSystem

© 2000 John Wiley & Sons, Inc.

2

Chapter Outcomes Describe the three ways in which

money is transferred from savers and investors

Explain why depository institutions are an important part of the monetary system

Describe the functions of money Give a brief review of the

development of money in the United States

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Chapter Outcomes(Continued)

Define the M1 money supply Briefly explain the M2, M3, and L

definitions of the money supply Explain possible relationships

between money supply and economic activity

Comment on developments in the international monetary system

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Savings-Investment Process

Money

Securities

Money Money

Money Money

Securities

Firm’s

Securities

Securities

Intermed’s

Securities

Investment Banking Firm

Direct Transfers:

Savers Business Firm

Indirect Transfers:

Savers Business

Firm

Savers Financial Business

Intermediary Firm

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Participants in the U.S. Monetary System

CENTRAL BANK:

Defines and Regulates Money Supply

Facilitates the Transferring of Money

BANKING SYSTEM:

Creates Money

Transfers Money

Provides Financial Intermediation

Processes/Clears Checks

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The U.S. Monetary SystemCentral Bank

Federal Reserve SystemBoard of Governors

Federal Reserve Banks

Defines and regulates money supply

Facilitates transfer of money through check processing/clearing

Banking System:1. Creates money2. Transfers money3. Provides financial intermediation4. Processes/clears checks

Other Banks

First Bank

Last Bank

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U.S. Central Bank

Federal Reserve System [often referred to as the “Fed”]

Board of Governors Federal Reserve Banks

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Central Bank Activities

Defines and regulates money supply Facilitates the transferring of money

through check processing and clearing

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Some Basic Definitions

MONEY: Anything that is generally accepted as payment

BARTER: Exchange of goods or services without using money

LIQUIDITY: How easily an asset can be exchanged for money

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Functions of Money

MEDIUM OF EXCHANGE: The basic function of money

STORE OF VALUE: Money can be held for some period of time, without losing its value, before it is spent

STANDARD OF VALUE: Exists when prices and debts are stated in terms of the monetary unit

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Historical Types of U.S. Coins

FULL-BODIED MONEY: Coins that contain the same value in metal as their face value

TOKEN COINS: Coins containing metal of less value than their stated value

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Historical Types of U.S. Paper Currency

REPRESENTATIVE FULL-BODIED MONEY: Paper money fully backed by a precious metal

FIAT MONEY: Legal tender proclaimed to be money by law (i.e., not backed by a precious metal)

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Deposit Money in the U.S.

CREDIT MONEY:CREDIT MONEY: Money worth more than what it is made of. It is backed by the “credit-worthiness” of the issuer

DEPOSIT MONEY:DEPOSIT MONEY: A special type of credit money backed by the depository institution that issued the deposit

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Alternatives to “Paper Checks”

AUTOMATIC TRANSFER SERVICE AUTOMATIC TRANSFER SERVICE (ATS) ACCOUNTS:(ATS) ACCOUNTS: Provide for direct deposits to, and payments from, checkable deposit accounts

DEBIT CARDS:DEBIT CARDS: Provide for immediate direct transfer of deposit amounts

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Components of the M1 Definition of the Money Supply

Currency Travelers Checks Demand Deposits at Banks Other Checkable Deposits at

Depository Institutions

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Components of the M2 Definition of the Money Supply

M1 Money Supply Savings Accounts at Depository

Institutions Small-Denomination Time Deposits Retail Money Market Mutual Funds

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Components of the M3 Definition of the Money Supply

M2 Money Supply Large-Denomination Time Deposits Institutional Money Market Mutual

Funds Repurchase Agreements (Overnight

and Term) Eurodollars (Overnight and Term)

Held by U.S. Residents

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Money Supply and Economic Activity Relationships

MONETARISTS’ VIEW:MONETARISTS’ VIEW: The amount of money in circulation determines the level of economic activity

KEYNESIANS’ VIEW:KEYNESIANS’ VIEW: Change in the money supply first causes a change in interest rates which, in turn, alters the demand for goods and services

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Monetarists’ View

BASIC EQUATION:BASIC EQUATION: GDP = MS x VM GROSS DOMESTIC PRODUCT (GDP):GROSS DOMESTIC PRODUCT (GDP):

Measures the output of goods and services in an economy

MONEY SUPPLY (MS):MONEY SUPPLY (MS): Usually defined in terms of M1 or M2

VELOCITY OF MONEY (VM):VELOCITY OF MONEY (VM): The rate of circulation of the money supply

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International Monetary System

Historically: Tied to the gold standard

Bretton Woods System (1944): Agreement to use fixed or pegged exchange rates tied to the U.S. dollar or gold

Early 1970s: Development of a flexible or floating exchange rate system