1. In this chapter, look for the answers to these questions:  What assets are considered “money”? What are the functions of money? The types of money?  What is the Federal Reserve?  What role do banks play in the monetary system? How do banks “create money”?  How does the Federal Reserve control the money supply? 0

2. 1 What Money Is and Why It’s Important Without money, goods and services have to be exchanged Every transaction would require a Most people would have to spend time With money people and hence society saves on Hence money fosters

3. 2 The 3 Functions of Money  Medium of exchange:  Unit of account:  Store of value:

4. 3 The 2 Kinds of Money Commodity money: Fiat money:

5. 4 Measures of the U.S. Money Supply  M1:  M2:

6. 5 Central Banks & Monetary Policy  Central bank:  Monetary policy:  Federal Reserve (Fed):

7. 6 The Structure of the Fed The Federal Reserve System consists of:  Board of Governors (7 members), located in Washington, DC  12 regional Fed banks, located around the U.S.  Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy. Ben S. Bernanke Chair of FOMC, Feb 2006 – present

8. 7 Bank Reserves  In a fractional reserve banking system,  The Fed establishes  Banks may hold more than  The reserve ratio,

9. 8 Bank T-account  T-account:  Example: FIRST NATIONAL BANK AssetsLiabilities  Banks’ liabilities include  In this example,

10. 9 Banks and the Money Supply: An Example Suppose $100 of currency is in circulation. To determine banks’ impact on money supply, we calculate the money supply in 3 different cases: 1.No banking system 2.100% reserve banking system: banks hold 100% of deposits as reserves, make no loans 3.Fractional reserve banking system

11. 10 Banks and the Money Supply: An Example CASE 1: No banking system

12. THE MONETARY SYSTEM 11 Banks and the Money Supply: An Example CASE 2: 100% reserve banking system Public deposits the $100 at First National Bank (FNB). FIRST NATIONAL BANK AssetsLiabilities FNB holds Money supply = In a 100% reserve banking system,

13. 12 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system Money supply = FIRST NATIONAL BANK AssetsLiabilities Suppose R = 10%.

14. 13 Banks and the Money Supply: An Example How did the money supply suddenly grow? CASE 3: Fractional reserve banking system A fractional reserve banking system

15. 14 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for SNB, it will SECOND NATIONAL BANK AssetsLiabilities Suppose borrower deposits the $90 at Second National Bank (SNB). Initially, SNB’s T-account looks like this:

16. 15 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for TNB, it will THIRD NATIONAL BANK AssetsLiabilities The borrower deposits Initially, TNB’s T-account looks like this:

17. 16 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system The process Original deposit = FNB lending = SNB lending = TNB lending =... $100.00... Total money supply =

18. 17 The Money Multiplier  Money multiplier:  The money multiplier equals  In our example,

19. Exercise - 1 18 While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Fed’s reserve requirement is 20% of deposits. A. What is the maximum amount that the money supply could increase? B. What is the minimum amount that the money supply could increase?

20. 19 The Fed’s 3 Tools of Monetary Control 1. Open-Market Operations (OMOs):  To increase money supply  To reduce money supply,

21. 20 The Fed’s 3 Tools of Monetary Control 2. Reserve Requirements (RR):  To increase money supply,  To reduce money supply,

22. 21 The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: When banks are running low on reserves,  To increase money supply,  To reduce money supply,

23. 22 The Federal Funds Rate On any given day, banks with insufficient reserves  The interest rate on  The FOMC uses OMOs to  Many interest rates are

24. The Fed Funds Rate and Other Rates, 1970-2008 (%) 0 5 10 15 20 19701975198019851990199520002005 Fed funds prime 3-month Tbill mortgage

25. 24 Monetary Policy and the Fed Funds Rate rfrf F D1D1 3.75% F2F2 F1F1 3.50% The Federal Funds market Federal funds rate Quantity of federal funds

26. 25 Problems Controlling the Money Supply  If households hold more of their money as currency  If banks hold more reserves than required,  Yet, Fed can compensate

27. 26 Bank Runs and the Money Supply  A run on banks:  Under fractional-reserve banking,  Also, banks may make  These events

28. 27 Bank Runs and the Money Supply  During 1929-1933, a wave of bank runs and bank closings caused money supply to fall 28%.  Many economists believe this contributed to the severity of the Great Depression.  Since then, federal deposit insurance has helped prevent bank runs in the U.S.  In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and was eventually taken over by the British government.