1. Chapter 2 The United States Monetary System © 2000 John Wiley & Sons, Inc.

2. 2 Chapter Outcomes n Describe the three ways in which money is transferred from savers and investors n Explain why depository institutions are an important part of the monetary system n Describe the functions of money n Give a brief review of the development of money in the United States

3. 3 Chapter Outcomes (Continued) n Define the M1 money supply n Briefly explain the M2, M3, and L definitions of the money supply n Explain possible relationships between money supply and economic activity n Comment on developments in the international monetary system

4. 4 S avings-Investment Process Money Securities Money Securities Firm’s Securities Intermed’s Securities Investment Banking Firm Direct Transfers: Savers Business Firm Indirect Transfers: Savers Business Firm Savers Financial Business Intermediary Firm

5. 5 Participants in the U.S. Monetary System CENTRAL BANK: Defines and Regulates Money Supply Facilitates the Transferring of Money BANKING SYSTEM: Creates Money Transfers Money Provides Financial Intermediation Processes/Clears Checks

6. 6 The U.S. Monetary System Central Bank Federal Reserve System Board of Governors Federal Reserve Banks Defines and regulates money supply Facilitates transfer of money through check processing/clearing Banking System: 1. Creates money 2. Transfers money 3. Provides financial intermediation 4. Processes/clears checks Other Banks First Bank Last Bank

7. 7 U.S. Central Bank n Federal Reserve System [often referred to as the “Fed”] n Board of Governors n Federal Reserve Banks

8. 8 Central Bank Activities n Defines and regulates money supply n Facilitates the transferring of money through check processing and clearing

9. 9 Some Basic Definitions n MONEY: Anything that is generally accepted as payment n BARTER: Exchange of goods or services without using money n LIQUIDITY: How easily an asset can be exchanged for money

10. 10 Functions of Money n MEDIUM OF EXCHANGE: The basic function of money n STORE OF VALUE: Money can be held for some period of time, without losing its value, before it is spent n STANDARD OF VALUE: Exists when prices and debts are stated in terms of the monetary unit

11. 11 Historical Types of U.S. Coins n FULL-BODIED MONEY: Coins that contain the same value in metal as their face value n TOKEN COINS: Coins containing metal of less value than their stated value

12. 12 Historical Types of U.S. Paper Currency n REPRESENTATIVE FULL-BODIED MONEY: Paper money fully backed by a precious metal n FIAT MONEY: Legal tender proclaimed to be money by law (i.e., not backed by a precious metal)

13. 13 Deposit Money in the U.S. n CREDIT MONEY: n CREDIT MONEY: Money worth more than what it is made of. It is backed by the “credit- worthiness” of the issuer n DEPOSIT MONEY: n DEPOSIT MONEY: A special type of credit money backed by the depository institution that issued the deposit

14. 14 Alternatives to “Paper Checks” n AUTOMATIC TRANSFER SERVICE (ATS) ACCOUNTS: n AUTOMATIC TRANSFER SERVICE (ATS) ACCOUNTS: Provide for direct deposits to, and payments from, checkable deposit accounts n DEBIT CARDS: n DEBIT CARDS: Provide for immediate direct transfer of deposit amounts

15. 15 Components of the M1 Definition of the Money Supply n Currency n Travelers Checks n Demand Deposits at Banks n Other Checkable Deposits at Depository Institutions

16. 16 Components of the M2 Definition of the Money Supply n M1 Money Supply n Savings Accounts at Depository Institutions n Small-Denomination Time Deposits n Retail Money Market Mutual Funds

17. 17 Components of the M3 Definition of the Money Supply n M2 Money Supply n Large-Denomination Time Deposits n Institutional Money Market Mutual Funds n Repurchase Agreements (Overnight and Term) n Eurodollars (Overnight and Term) Held by U.S. Residents

18. 18 Money Supply and Economic Activity Relationships n MONETARISTS’ VIEW: n MONETARISTS’ VIEW: The amount of money in circulation determines the level of economic activity n KEYNESIANS’ VIEW: n KEYNESIANS’ VIEW: Change in the money supply first causes a change in interest rates which, in turn, alters the demand for goods and services

19. 19 Monetarists’ View n BASIC EQUATION: n BASIC EQUATION: GDP = MS x VM n GROSS DOMESTIC PRODUCT (GDP): n GROSS DOMESTIC PRODUCT (GDP): Measures the output of goods and services in an economy n MONEY SUPPLY (MS): n MONEY SUPPLY (MS): Usually defined in terms of M1 or M2 n VELOCITY OF MONEY (VM): n VELOCITY OF MONEY (VM): The rate of circulation of the money supply

20. 20 International Monetary System n Historically: Tied to the gold standard n Bretton Woods System (1944): Agreement to use fixed or pegged exchange rates tied to the U.S. dollar or gold n Early 1970s: Development of a flexible or floating exchange rate system