1. © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney Prepared by: Fernando & Yvonn Quijano

2. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 2 of 26 The FOMC’s decision about interest rates is anxiously watched by traders like these, and by investors around the world. What you will learn in this chapter: ➤ The various roles money plays and the many forms it takes in the economy ➤ How the actions of private banks and the Federal Reserve determine the money supply ➤ How the Federal Reserve uses open- market operations to change interest rates ➤ How monetary policy affects aggregate output in the short run

3. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 3 of 26 The Meaning of Money A household’s wealth is the value of its accumulated savings.

4. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 4 of 26 The Meaning of Money Money is any asset that can easily be used to purchase goods and services. What Is Money? Currency in circulation is cash held by the public. Checkable bank deposits are bank accounts on which people can write checks. The money supply is the total value of financial assets in the economy that are considered money. An asset is liquid if it can be quickly converted into cash without much loss of value.

5. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 5 of 26 The Meaning of Money A medium of exchange is an asset that individuals acquire for the purpose of trading rather than for their own consumption. Roles of Money Medium of Exchange

6. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 6 of 26 The Meaning of Money A store of value is a means of holding purchasing power over time. Roles of Money Store of Value A unit of account is a measure used to set prices and make economic calculations. Unit of Account

7. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 7 of 26 The Meaning of Money Commodity money is a good used as a medium of exchange that has other uses. Types of Money A commodity-backed money is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods. Fiat money is a medium of exchange whose value derives entirely from its official status as a means of payment.

8. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 8 of 26 The Meaning of Money A monetary aggregate is an overall measure of the money supply. Measuring the Money Supply Near-moneys are financial assets that can’t be directly used as a medium of exchange but can be readily converted into cash or checkable bank deposits.

9. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 9 of 26 The Meaning of Money Measuring the Money Supply

10. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 10 of 26 The Monetary Role of Banks What Banks Do A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs of borrowers. A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets. A bank deposit is a claim on a bank that obliges the bank to give the depositor his or her cash when demanded. Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve.

11. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 11 of 26 The Monetary Role of Banks What Banks Do

12. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 12 of 26 The Monetary Role of Banks What Banks Do The reserve ratio is the fraction of bank deposits that a bank holds as reserves. An asset is a claim that provides income in the future. A liability is a requirement to pay in the future.

13. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 13 of 26 The Monetary Role of Banks The Problem of Bank Runs A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure.

14. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 14 of 26 The Monetary Role of Banks Bank Regulation Deposit insurance guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. Deposit Insurance

15. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 15 of 26 The Monetary Role of Banks Bank Regulation To reduce the incentive for excessive risk taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits. Capital Requirements Reserve Requirements Reserve requirements are rules set by the Federal Reserve that determine the minimum reserve ratio for a bank.

16. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 16 of 26 The Monetary Role of Banks How Banks Create Money Excess reserves are a bank’s reserves over and above its required reserves.

17. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 17 of 26 The Federal Reserve System The Fed: America’s Central Bank A central bank is an institution that oversees and regulates the banking system and controls the monetary base.

18. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 18 of 26 The Federal Reserve System The Fed: America’s Central Bank

19. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 19 of 26 The Federal Reserve System What the Fed Does: Reserve Requirements and the Discount Rate The federal funds market allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves. The federal funds rate is the interest rate determined in the federal funds market. The discount rate is the rate of interest the Fed charges on loans to banks.

20. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 20 of 26 The Federal Reserve System Open-Market Operations An open-market operation is a purchase or sale of government debt by the Fed.

21. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 21 of 26 Monetary Policy and Aggregate Demand Expansionary and Contractionary Monetary Policy The target federal funds rate is the Federal Reserve’s desired federal funds rate.

22. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 22 of 26 Monetary Policy and Aggregate Demand Expansionary and Contractionary Monetary Policy Expansionary monetary policy is monetary policy that increases aggregate demand.

23. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 23 of 26 Monetary Policy and Aggregate Demand Expansionary and Contractionary Monetary Policy Contractionary monetary policy is monetary policy that reduces aggregate demand.

24. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 24 of 26 Monetary Policy and Aggregate Demand Monetary Policy and the Multiplier (18-1)

25. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 25 of 26 economics in action The Fed and the Output Gap, 1985–2004

26. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 26 of 26 Money Currency in circulation Checkable bank deposits Money supply Medium of exchange Store of value Unit of account Commodity money Commodity-backed money Fiat money Monetary aggregate Near-moneys Bank Financial intermediary Bank deposit Bank reserves Asset Liability Reserve ratio Bank run Deposit insurance Reserve requirements Excess reserves Central bank Federal funds market Federal funds rate Discount rate Open-market operation Target federal funds rate Expansionary monetary policy Contractionary monetary policy K E Y T E R M S