Harcourt Brace & Company Chapter 15 The Monetary System

Harcourt Brace & Company The Meaning of Money u Money is the set of assets in the economy that people regularly use to buy goods and services from other people.

Harcourt Brace & Company 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 readily spendable form for future needs.

Harcourt Brace & Company The Two Types of Money u Commodity Money: something that performs the function of money and has alternative, nonmonetary uses. –Examples: Gold, silver, cigarettes u Fiat Money: something that serves as money but has no other important uses. –Examples: Coins, currency, check deposits

Harcourt Brace & Company Money in the U.S. Economy u Money Stock is the quantity of money circulating in the economy. u Different ways of measuring the money stock in the economy: – M1 – M2

Harcourt Brace & Company u The most familiar form of money used includes: –Coins –Currency –Check Deposits –Travelers Checks Measurement of Money M1M1

Harcourt Brace & Company Measurement of Money u A broader measure of money than M 1, includes: –M1 + –Savings Deposits + –Small Time Deposits + –Money Market Mutual Funds + –and other minor categories M2M2

Harcourt Brace & Company Where is All The Currency? u In 1996 there was about $380 billion of U.S. currency outstanding ($1,900 in currency per person). u Location of outstanding currency may include: –Currency held abroad –Currency held by illegal entities –Currency held in businesses for transac- tion purposes

Harcourt Brace & Company Quick Quiz! u List and describe the three functions of money.

Harcourt Brace & Company The Federal Reserve u The Federal Reserve (“Fed”) serves as the nation’s central bank, which is designed to oversee the banking system and regulate the quantity of money in the economy. u The “Fed” is a privately owned institution, authorized in 1914 by Congress to ensure the health of the nation’s banking system.

Harcourt Brace & Company The Fed’s Organization u 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.

Harcourt Brace & Company The Fed’s Organization u The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C. and twelve regional Federal Reserve Banks. u Monetary policy is made by the Federal Open-Market Committee.

Harcourt Brace & Company Three Primary Functions of the Fed ¬ Regulate the private banking industry to make sure banks follow federal laws intended to promote safe and sound banking practices. ­ Act as a banker’s bank, making loans to other banks and as a lender of last resort. ® Control of the supply of money i.e. Monetary Policy.

Harcourt Brace & Company Money Supply Changes by the Fed u 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.

Harcourt Brace & Company Quick Quiz! u How does the Fed increase the supply of money in the economy?

Harcourt Brace & Company Banks and The Money Supply u The behavior of banks can influence the quantity of demand deposits in the economy and therefore, the money supply. u Fractional Reserve Banking System: The practice of holding a fraction of money deposited as reserves and lending out the rest.

Harcourt Brace & Company Fractional Reserve Banking u Deposits into a bank are recorded as both assets and liabilities. Deposits that have been received but not lent out are called reserves. u The supply of money in the economy is affected by the amount of deposits that are kept in the bank as reserves and the amount that is lent out. Loans become an asset to the bank.

Harcourt Brace & Company Bank “T-Account” Example AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $100.00

Harcourt Brace & Company Bank “T-Account” Example A “T-Account” illustrates the financial position of a bank that accepts deposits, keeps a portion as reserves and lends out the rest. AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $100.00

Harcourt Brace & Company Money Creation with Fractional-Reserve Banking u When a bank makes a loan (from it’s reserves) the money supply increases. When banks hold only a fraction of deposits in reserve, banks create money. u 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.

Harcourt Brace & Company The Money Multiplier u 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. u The Money Multiplier is the amount of money that the banking system generates with each dollar of reserves.

Harcourt Brace & Company The Money Multiplier AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $100.00

Harcourt Brace & Company The Money Multiplier AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $ AssetsLiabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

Harcourt Brace & Company The Money Multiplier AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $ AssetsLiabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

Harcourt Brace & Company The Money Multiplier AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $ AssetsLiabilities 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!

Harcourt Brace & Company What determines the size of the money multiplier? u The money multiplier is the reciprocal of the reserve ratio. –With a reserve requirement (R) of 20% or 1/5... –The multiplier will be 5. 1R 1R M =

Harcourt Brace & Company Tools of Monetary Control The Fed has three instruments of monetary control: u Open-Market Operations: –Buying and selling bonds. u Changing the Reserve Ratio: –Increasing or decreasing the ratio. u Changing the Discount Rate: –The interest rate the Fed charges other banks for loans.

Harcourt Brace & Company Problems in Controlling the Money Supply u 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.