© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Overview of Money Money is anything that is generally accepted as a medium of exchange.Money is anything that is generally accepted as a medium of exchange. Money is not income, and money is not wealth. Money is:Money is not income, and money is not wealth. Money is: a means of payment, a means of payment, a store of value, and a store of value, and a unit of account. a unit of account.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Overview of Money Money as a means of payment, or medium of exchange, is more efficient than barter.Money as a means of payment, or medium of exchange, is more efficient than barter. Barter is the direct exchange of goods and services for other goods and services.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.A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem. Money is a lubricant in the functioning of a market economy.Money is a lubricant in the functioning of a market economy.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Overview of Money Money as a store of value refers to money as an asset that can be used to transport purchasing power from one time period to another.Money as a store of value refers to money as an asset that can be used to transport purchasing power from one time period to another. 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Overview of Money Money also serves as a unit of account, or a standard unit that provides a consistent way of quoting prices.Money also serves as a unit of account, or a standard unit that provides a consistent way of quoting prices. Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money.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, or token, money is money that is intrinsically worthless. Legal tender is money that a government has required to be accepted in settlement of debts.Legal tender is money that a government has required to be accepted in settlement of debts.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Measuring the Supply of Money in the United States The two most common measures of money are M1 and M2.The two most common measures of money are M1 and M2. M1, or transactions money is money that can be directly used for transactions. It includes currency held outside banks, plus demand deposits, plus traveler’s checks, plus other checkable depositsM1, or transactions money is money that can be directly used for transactions. It includes currency held outside banks, plus demand deposits, plus traveler’s checks, plus other checkable deposits M1 is a stock measure—it is measured at a point in time—on a specific day. On June 26, 2000, M1 was $1,103.3 billion.M1 is a stock measure—it is measured at a point in time—on a specific day. On June 26, 2000, M1 was $1,103.3 billion.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Measuring the Supply of Money in the United States M2, or broad money, includes near monies, or close substitutes for transactions money.M2, or broad money, includes near monies, or close substitutes for transactions money. M2 / M1 + savings accounts + money market accounts + other near monies M2 / M1 + savings accounts + money market accounts + other near monies On June 26, 2000, M2 was $4,778.2 billion.On June 26, 2000, M2 was $4,778.2 billion. The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Private Banking System Most of the money in the United States today is “bank money,” or money held in checking accounts rather than currency.Most of the money in the United States today is “bank money,” or money held in checking accounts rather than currency. 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair How Banks Create Money To see how banks create money, consider the origins of the modern banking system:To see how banks create money, consider the origins of the modern banking system: Goldsmiths functioned as warehouses where people stored gold for safekeeping. 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, rather than the gold that they represented, began to be traded for goods. Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves, rather than the gold that they represented, began to be traded for goods. At this point, all the receipts issued were backed 100 percent by gold. At this point, all the receipts issued were backed 100 percent by gold.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair How Banks Create Money Goldsmiths realized that people did not come often to withdraw gold and, as a result, they had a large stock of gold continuously on hand. They could lend out some of this gold without any fear of running out. Goldsmiths realized that people did not come often to withdraw gold and, as a result, they had a large stock of gold continuously on hand. They could lend out some of this gold without any fear of running out. There were thus more claims than there were ounces of gold. There were thus more claims than there were ounces of gold.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair How Banks Create Money Knowing there were more receipts outstanding than there were ounces of gold, people might start to demand gold for receipts. Knowing there were more receipts outstanding than there were ounces of gold, people might start to demand gold for receipts. A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time. A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Modern Banking System A brief review of accounting: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 (or vault cash) and deposits with the Fed.A bank’s most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the Fed. The Federal Reserve System (the Fed) is the central bank of the United States.The Federal Reserve System (the Fed) is the central bank of the United States. A bank’s liabilities are the promises to pay, or IOUs, that it has issued. A bank’s most important liabilities are its deposits.A bank’s liabilities are the promises to pay, or IOUs, that it has issued. A bank’s most important liabilities are its deposits.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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).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) ASSETSLIABILITIES Reserves20100Deposits Loans9010 Net worth Total110110Total

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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).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).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Creation of Money When someone deposits $100, and the bank deposits the $100 with the central bank, it has $100 in reserves.When someone deposits $100, and the bank deposits the $100 with the central bank, it has $100 in reserves. If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can lend $400 and have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can lend $400 and have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Creation of Money Balance Sheets of a Bank in a Single-Bank Economy Panel 1 Panel 2 Panel 3 ASSETSLIABILITIESASSETSLIABILITIESASSETSLIABILITIES Reserves 0 0 Deposits Reserves Deposits Reserves Deposits Loans 400

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Creation of Money The Creation of Money: Balance Sheets of Three Banks Panel 1 Panel 2 Panel 3 ASSETSLIABILITIESASSETSLIABILITIESASSETSLIABILITIES Reserves Deposits Reserves 100 Loans Deposits Reserves 20 Loans Deposits Reserves Deposits Reserves 80 Loans Deposits Reserves 16 Loans Deposits Reserves Deposits Reserves Deposits Reserves Deposits Summary:Deposits Bank Bank 2 80 Bank 3 64 Bank Total500.00

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Money Multiplier The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves. If the required reserve ratio is 10%, then an increase in reserves of $1 could cause an increase in deposits of $10 if there were no leakage out of the system.If the required reserve ratio is 10%, then an increase in reserves of $1 could cause an increase in deposits of $10 if there were no leakage out of the system.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Federal Reserve System

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Federal Reserve System

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Functions of the Fed Clearing interbank payments.Clearing interbank payments. Regulating the banking system.Regulating the banking system. Assisting banks in a difficult financial position.Assisting banks in a difficult financial position. Managing exchange rates and the nation’s foreign exchange reserves.Managing exchange rates and the nation’s foreign exchange reserves. The Fed performs important functions for banks including:

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Functions of the Fed Control of mergers between banks.Control of mergers between banks. Examination of banks to ensure that they are financially sound.Examination of banks to ensure that they are financially sound. Setting of reserve requirements for all financial institutions.Setting of reserve requirements for all financial institutions. Lender of last resort.Lender of last resort. The Fed performs important functions for banks including:

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Fed’s Balance Sheet Assets and Liabilities of the Federal Reserve System, April 30, 2000 (millions of dollars) ASSETSLIABILITIES Gold$11,048$535,349 Federal Reserve notes (outstanding) Loans to banks 25,145Deposits: U.S. Treasury 506,69513,480 Bank reserves (from depository institutions) securities15,868 U.S. Treasury All other assets 46,83925,030 All other liabilities and net worth Total$589,727$589,727Total Source: Federal Reserve Bulletin, July 2000, Table 1.18.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Fed’s Balance Sheet Although it is unrelated to the money supply, the Fed’s gold counts as an asset on its 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.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.A dollar bill is a liability, or IOU, of the Fed.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair How the Fed Controls the Money Supply 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.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, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves.If the Fed wants to increase the money supply, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair How the Fed Controls the Money Supply 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 AssetsLiabilitiesAssetsLiabilities Government$200$100ReservesReserves$100$500Deposits securities$100CurrencyLoans$400 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% Federal Reserve Commercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100ReservesReserves$100$800Deposits securities$100Currency Loans (+ $300) $700 (+ $300) Note: Money supply (M1) = Currency + Deposits = $900.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Discount Rate Banks may borrow from the Fed. The interest rate they pay the Fed is the discount rate.Banks may borrow from the Fed. The interest rate they pay the Fed is the discount rate. 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 AssetsLiabilitiesAssetsLiabilities Securities$160$80ReservesReserves$80$400Deposits $80CurrencyLoans$320 Note: Money supply (M1) = Currency + Deposits = $480. PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED Federal Reserve Commercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$100 Reserves (+ $20) $100$500 Deposits (+ $300) Loans$20$80Currency Loans (+ $100) $420$20 Amount owed to Fed (+ $20) Note: Money supply (M1) = Currency + Deposits = $580.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Discount Rate In practice, the Fed does not often use the discount rate to control the money supply.In practice, the Fed does not often use the discount rate to control the money supply. The discount rate cannot be used to control the money supply with great precision, because its effects on banks’ demand for reserves are uncertain.The discount rate cannot be used to control the money supply with great precision, because its effects on banks’ demand for reserves are uncertain. Moral suasion is the pressure exerted by the Fed on member banks to discourage them from borrowing heavily from the Fed.Moral suasion is the pressure exerted by the Fed on member banks to discourage them from borrowing heavily from the Fed.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 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.Open market operations is by far the most significant tool of the Fed for controlling the supply of money.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities$100$20ReservesReserves$20$100DepositsDeposits$5$0Debts $80CurrencyLoans$80$5 Net Worth Note: Money supply (M1) = Currency + Deposits = $180. $80Currency PANEL 2 Federal Reserve Commercial Banks Jane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15 Reserves (  $5) $15$95 Deposits (  $5) $0$0Debts $80CurrencyLoans$80 Securities (+ $5) $5$5 Net Worth Note: Money supply (M1) = Currency + Deposits = $175. PANEL 2 Federal Reserve Commercial Banks Jane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15 Reserves (  $5) $15$75 Deposits (  $25) Deposits (  $5) $0$0Debts $80Currency Loans (  $20) $60 Securities (+ $5) $5$5 Net Worth Note: Money supply (M1) = Currency + Deposits = $155.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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. 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Open Market Operations Open market operations are the Fed’s preferred means of controlling the money supply because:Open market operations are the Fed’s preferred means of controlling the money supply because: they can be used with some precision, they can be used with some precision, are extremely flexible, and are extremely flexible, and are fairly predictable. are fairly predictable.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 says the Fed sets the money supply independent of the interest rate.