m & b session 4 & 5.ppt
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The Monetary System
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The Meaning of Money
Money is the set of assets in the economy that
people regularly use to buy goods and services
from other people.
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Three Functions of Money
Medium of Exchange: anything that is readily acceptable as
payment.
Unit of Account: serves as a unit of account to help us
compare the relative values of goods.
Store of Value: a way to keep some of our wealth in a readilyspendable form for future needs.
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The Two Types of Money
Commodity Money: something that performs the function of money
and has alternative, nonmonetary uses.
Examples: Gold, silver, cigarettes
Fiat Money: something that serves as money but has no other
important uses.
Examples: Coins, currency, check deposits
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Money in the U.S. Economy
Money Stock is the quantity of money circulating in the
economy.
Different ways of measuring the money stock in the economy:
M1 M2
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Measurement of Money
The most familiar form of money usedincludes:
Coins
Currency
Check Deposits Travelers Checks M
1
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Measurement of Money
A broader measure of money than M1,includes: M1 +
Savings Deposits +
Small Time Deposits +
Money Market Mutual Funds +
and other minor categories M2
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Where is All The Currency?
In 1996 there was about $380 billion of U.S. currency
outstanding ($1,900 in currency per person).
Location of outstanding currency may include:
Currency held abroad
Currency held by illegal entities
Currency held in businesses for transac-tion purposes
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The Federal Reserve
The Federal Reserve (Fed) serves as the nations central
bank, which is designed to oversee the banking system and
regulate the quantity of money in the economy.
The Fed is a privately owned institution, authorized in 1914
by Congress to ensure the health of the nations bankingsystem.
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The Feds Organization
The Fed is run by its Board of Governors.
Seven members appointed by the President of the United States.
The Chairman of the Board is the most important position:
presiding, directing, and testifying about Fed policy. She/He is
appointed by the President.
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The Feds Organization
The Federal Reserve System is made up of the Federal Reserve Board in
Washington, D.C. and twelve regional Federal Reserve Banks.
Monetary policy is made by the Federal Open-Market Committee.
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Three Primary Functions of the
FedRegulate the private banking industry to make sure banks follow
federal laws intended to promote safe and sound banking practices.
Act as a bankers bank, making loans to other banks and as a lender
of last resort.
Control of the supply of money i.e. Monetary Policy.
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Money Supply Changes by the Fed
Open-Market Operations: The primary way in which the Fed
changes the money supply done through the purchase and sale
of U.S. government bonds with newly printed money.
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.
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Banks and The Money Supply
The behavior of banks can influence the quantity of demand
deposits in the economy and therefore, the money supply.
Fractional Reserve Banking System: The practice of holding a
fraction of money deposited as reserves and lending out the
rest.
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Fractional Reserve Banking
Deposits into a bank are recorded as both assets and
liabilities. Deposits that have been received but not lent out
are called reserves.
The supply of money in the economy is affected by the
amount of deposits that are kept in the bank as reserves andthe amount that is lent out. Loans become an asset to the
bank.
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Bank T-Account Example
Assets Liabilities
First National Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
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Bank T-Account Example
A T-Account
illustrates the
financial position of a
bank that acceptsdeposits, keeps a
portion as reserves
and lends out therest.
Assets Liabilities
First National Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
M C i i h
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Money Creation with
Fractional-Reserve Banking
When a bank makes a loan (from its reserves) the money supply
increases. When banks hold only a fraction of deposits in reserve,
banks create money.
The creation of money through loans does not create any wealth,
but allows banks to charge interest several times on the same bit
of wealth.
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The Money Multiplier
When one bank loans money, that money is generally
deposited into another or the same bank thus creating more
deposits and more reserves to be lent out.
The Money Multiplieris the amount of money that the
banking system generates with each dollar of reserves.
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The Money Multiplier
Assets Liabilities
First National Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
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The Money Multiplier
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
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The Money Multiplier
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
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The Money Multiplier
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
Total Money Supply = $190.00!
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Tools of Monetary ControlThe Fed has three instruments of monetary control:
Open-Market Operations: Buying and selling bonds.
Changing the Reserve Ratio:
Increasing or decreasing the ratio.
Changing the Discount Rate:
The interest rate the Fed charges other banks for loans.
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Problems in Controlling the
Money Supply
Two problems that the Fed must wrestle 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.
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