Introduction to Macroeconomics Chapter 26 Money, Banking and the Federal Reserve

Money, Banking, & the Federal Reserve 1. Barter Economy 2. Characteristics of Money 3. Definition of Money 4. Fractional Reserve Banking 5. How Banks Create Money 6. Federal Reserve Policy Tools

1. Barter Economy Transaction Costs Barter - direct trade of one good for another Transaction Costs: double coincidence of wants problem of divisibility negotiating relative values

2. Characteristic of Money General Characteristics Medium of Exchange - item generally acceptable as payment for goods and services. Avoids double coincidence of wants. Store of Value - money can be accumulated without deterioration or loss. No problem with divisibility. Unit of Account - money is a standard unit for quoting prices and establishing relative values. Reduces negotiation costs.

2. Characteristics of Money Commodity Money scarce relative to other commodities stable in supply portable divisible durable Problems: opportunity cost debasing (Gresham’s Law) can’t directly control supply

2. Characteristics of Money Representative Money Paper money that can be exchanged for a specific commodity, like silver or gold. Advantages: Lower opportunity cost Eliminates debasing Problems: Depends on value of underlying commodity Counterfeiting Lower Opportuinity Cost - don’t have to hold gold reserves equivalent to all money in circulation. Can purchase/trade for commodity if needed.

2. Characteristics of Money Fiat Money Paper money that is solely money because the government says it is Generally not backed by a valuable commodity such as god but is backed by the “full faith and credit of the government” Advantages: No opportunity cost Not dependent on value of a commodity Disadvantages No restraint in printing money

3. Definitions of Money Categorized by Liquidity Liquidity - how easily money can be used to make purchases Monetary Base - currency held by public + currency held in bank vaults (reserves) M1 = currency held by public plus checking deposits M2 = M1 + savings deposits + small (less than $100,000) time deposits (CDs) M3 = M2 + large (more than $100,000) time deposits

3. Definitions of Money M1 Source: Federal Reserve, H-6 Statistical Release, Table 4, September 2001.

3. Definitions of Money M2 Source: Federal Reserve, H-6 Statistical Release, Table 5, September 2001.

4. Fractional Reserve Banking Banks hold reserves (cash in their vault) that are only a fraction of their demand deposits (e.g., checking and savings accounts) Banks make a profit by charging a higher interest rate for loans than is paid for deposits.

4. Fractional Reserve Banking Risks Bank runs Bank failures because of bad loans Institutions to reduce risks: FDIC deposit insurance Federal Reserve System bank regulations

4. Fractional Reserve Banking Key Measurements Demand Deposits (D) - total of checking and savings account Required Reserve Ratio (r) - fraction of D established by Federal Reserve Required Reserves, RR = r * D Total Reserves = cash in bank vaults Excess Reserves = Total Reserves - RR

5. How Banks Create Money Money Multiplier Money Multiplier = 1 / r Maximum Possible Increase in Money Supply = Initial change in monetary base x money multiplier

5. How Banks Create Money Money Multiplier at Work

6. Federal Reserve Policy Tools The Federal Reserve System Created by act of Congress in 1913 The Federal Reserve System (often called "the Fed") was formed in 1913 after panic of 1907. The Fed is the primary regulatory agency covering commercial banking. The responsibilities of the Fed include: - Controlling amount of money in U.S. - Lender of last resort - Acts as "bankers" bank (e.g., go through Fed on wire transfers, makes loans) - Supervises and inspects local banks - Acts as the Federal government's bank

6. Federal Reserve Policy Tools Policy Options Open Market Operations - buy and sell T-Bills Discount Rate - interest rate charged by Fed for overnight loans to banks Required Reserve Ratio Stock Market Margin Requirements Moral Persuasion

6. Federal Reserve Policy Tools Open Market Operations Open Market Operation - purchase or sale of government securities (T-bills) on the open market T-Bill Par Value: cash-in value when T-Bill matures Interest Rate - difference between par value of T-Bill and and purchase price

6. Federal Reserve Policy Tools Expansionary Policy Objective: Lower Interest Rate Fed buys T-Bills (increase in money supply) Market price of T-Bills increase Difference between market price and par value declines. Result: Lower interest rate

6. Federal Reserve Policy Tools Open Market Operations + represents increase, - represents decrease

6. Federal Reserve Policy Tools Summary of Policy Options

6. Federal Reserve Policy Tools Money and the Unemployment Rate Ratio: Reserves-to-Required Reserves Monetary Base Unemployment Rate