The Money Supply and the Federal Reserve System

An Overview of Money Money is anything that is generally accepted as a medium of exchange. Money is not income, and money is not wealth. Money is: a means of payment, a store of value, and a unit of account.

What is Money? Barter is the direct exchange of goods and services for other goods and services. A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem. As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as means of payment for goods and services.

What is Money? As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.

What is Money? As a unit of account, money is a standard that provides a consistent way of quoting prices.

What is Money? Money is easily portable, and easily exchanged for goods at all times. The liquidity property of money makes money a good medium of exchange as well as a store of value.

Commodity and Fiat Monies Gold Standard: Govt. issues paper currency backed by gold. Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money. Fiat, or token, money is money that is intrinsically worthless.

Fiat Money Fiat, or token money is : Pieces of paper that are essentially worthless but are accepted in exchange for goods Value of money supported by beliefs We believe others will accept the currency so we do as well

Commodity and Fiat Monies Legal tender is money that a government has required to be accepted in settlement of debts. Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.

Measuring the Supply of Money in the United States M0 (monetary base) = currency, bank reserves at the Fed M1, or transactions money is money that can be directly used for transactions. M1  currency held outside banks + demand deposits + traveler’s checks + (checking) + assets widely used for transactions + other checkable deposits M1 is a stock measure—it is measured at a point in time—on a specific day.

Measuring the Supply of Money in the United States Traveler's checks is : a cheque for a fixed amount, sold by a bank or travel agent that can be exchanged for cash in foreign countries

Measuring the Supply of Money in the United States M2, or broad money, includes near monies, or close substitutes for transactions money. M2 = M1 + savings accounts + money market accounts + other near monies The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

Measuring the Supply of Money in the United States M2 = M1 + savings deposits + small-denomination time deposits + money market accounts + additional assets that can be easily converted to assets used in transactions M3 = M2 + large denomination time deposits + other assets that are less liquid

The Private Banking System Banks and other financial institutions borrow from individuals or firms with excess funds and lend to those who need funds. That’s why they’re called financial intermediaries. The main types of financial intermediaries are commercial banks.

The Private Banking System Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

How Banks Create Money A Historical Perspective: Goldsmiths Goldsmiths functioned as warehouses where people stored gold for safekeeping. Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves began to be traded for goods, and were backed 100 percent by gold. Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold.

The Modern Banking System Assets are things a firm owns that are worth something. A bank’s assets are its loans, cash in hand, and reserve deposits at the Federal Reserve. Liabilities are the firm’s debts—what it owes. A bank’s liabilities are deposits owed to customers. 2. Banks are legally required to hold a certain minimum percentage of their deposit liabilities as reserves. The percentage is the required reserve ratio.

The Modern Banking System A brief review of accounting: Assets – liabilities / Net Worth, or Assets / Liabilities + Net Worth A bank’s most important assets are its loans. Other assets include cash on hand and deposits with the Fed. A bank’s liabilities are its debts—what it owes. Deposits are debts owed to the bank’s depositors.

The Modern Banking System The Federal Reserve System (the Fed) is the central bank of the United States.

The Modern Banking System Reserves are the deposits that a bank has at the Federal Reserve bank plus its cash on hand. The required reserve ratio is the percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

T-Account for a Typical Bank The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth). T-Account for a Typical Bank (millions of dollars) ASSETS LIABILITIES Reserves 20 100 Deposits Loans 90 10 Net worth Total 110

The Creation of Money Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).

The Creation of Money When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves. Balance Sheets of a Bank in a Single-Bank Economy In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400. Panel 1 Panel 2 Panel 3 ASSETS LIABILITIES Reserves 0 0 Deposits Reserves 100 100 Deposits 500 Deposits Loans 400

The Creation of Money If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits. Balance Sheets of a Bank in a Single-Bank Economy In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400. Panel 1 Panel 2 Panel 3 ASSETS LIABILITIES Reserves 0 0 Deposits Reserves 100 100 Deposits 500 Deposits Loans 400

The Creation of Money The Creation of Money When There Are Many Banks Panel 1 Panel 2 Panel 3 ASSETS LIABILITIES Reserves 100 100 Deposits Reserves 100 Loans 80 180 Deposits Reserves 20 Loans 80 Reserves 80 80 Deposits Reserves 80 Loans 64 144 Deposits Reserves 16 Loans 64 Reserves 64 64 Deposits 115.20 Deposits Reserves 12.80 .00 500 Total . . . .20 51 Bank 4 64 Bank 3 80 Bank 2 100 Bank 1 Deposits Summary:

The Money Multiplier .00 500 Total . . . .20 51 Bank 4 64 Bank 3 80 Bank 2 100 Bank 1 Deposits Summary: The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves. In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.

The Federal Reserve System

The Federal Reserve System

The Federal Reserve System The Federal Open Market Committee (FOMC) sets goals regarding the money supply and interest rates and directs the operations of the Open Market Desk in New York. The Open Market Desk is an office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed.

Functions of the Federal Reserve The Fed performs important functions for banks including: Clearing interbank payments. Regulating the banking system. Assisting banks in a difficult financial position. Managing exchange rates and the nation’s foreign exchange reserves. Control of mergers between banks.

Functions of the Federal Reserve The Fed performs important functions for banks including: Examination of banks to ensure that they are financially sound. Setting of reserve requirements for all financial institutions. Lender of last resort: The Fed provides funds to troubled banks that cannot find any other sources of funds.

The Federal Reserve Balance Sheet Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars) ASSETS LIABILITIES Gold $ 11,045 $593,031 Federal Reserve notes (outstanding) Loans to banks 36,538 Deposits: U.S. Treasury securities 550,314 20,359 Bank reserves (from depository institutions) 6,219 U.S. Treasury All other assets 46,268 24,556 All other liabilities and net worth Total 644,165 $644,165 Source: Federal Reserve Bulletin, August 2003, Table 1.18.

The Federal Reserve Balance Sheet Although it is unrelated to the money supply, the Fed’s gold counts as an asset on its balance sheet. The largest of the Fed’s assets, by far, consists of government securities purchased over the years. A dollar bill is a liability, or IOU, of the Fed.

How the Federal Reserve Controls the Money Supply Three tools are available to the Fed for changing the money supply: changing the required reserve ratio; changing the discount rate; and engaging in open market operations.

The Required Reserve Ratio The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create. If the Fed wants to increase the money supply, the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans. Since changing this ratio changes the money multiplier, a small change in the required reserve ratio will have a very large impact on the money supply

The Required Reserve Ratio A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) PANEL 1: REQUIRED RESERVE RATIO = 20% Federal Reserve Commercial Banks Assets Liabilities Government $200 $100 Reserves $500 Deposits securities Currency Loans $400 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% $800 Loans (+ $300) $700 (+ $300) Note: Money supply (M1) = Currency + Deposits = $900.

The Discount Rate The discount rate is the interest rate that banks pay to the Fed to borrow from it. Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

The Discount Rate The Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED Federal Reserve Commercial Banks Assets Liabilities Securities $160 $80 Reserves $400 Deposits Currency Loans $320 Note: Money supply (M1) = Currency + Deposits = $480. PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED $100 Reserves (+ $20) $500 Deposits (+ $300) $20 Loans (+ $100) $420 Amount owed to Fed (+ $20) Note: Money supply (M1) = Currency + Deposits = $580.

Open Market Operations Open market operations is the purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply. Open market operations is by far the most significant tool of the Fed for controlling the supply of money.

The Mechanics of Open Market Operations Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) PANEL 1 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Securities $100 $20 Reserves Deposits $5 $0 Debts $80 Currency Loans Net Worth Note: Money supply (M1) = Currency + Deposits = $180. PANEL 2 Securities (- $5) $95 $15 Reserves (- $5) Deposits (- $5) Securities (+ $5) Note: Money supply (M1) = Currency + Deposits = $175. PANEL 3 $75 Deposits (- $25) Loans (- $20) $60 Note: Money supply (M1) = Currency + Deposits = $155.

Open Market Operations An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

Open Market Operations An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

Open Market Operations Open market operations are the Fed’s preferred means of controlling the money supply because: they can be used with some precision, are extremely flexible, and are fairly predictable.

The Supply Curve for Money A vertical money supply curve says the Fed sets the money supply independent of the interest rate. A vertical money supply curve means the interest rate does not affect the Fed's decision on how much money to supply

Review Terms and Concepts barter commodity monies currency debasement discount rate excess reserves Federal Open Market Committee (FOMC) Federal Reserve System (the Fed) fiat, or token, money financial intermediaries legal tender lender of last resort liquidity property of money M1, or transactions money M2, or broad money medium of exchange, or means of payment money multiplier near monies Open Market Desk open market operations required reserve ratio reserves run on a bank store of value unit of account