The Monetary System

The Meaning of Money

Money is the set of assets in the economy that people regularly use to buy goods and services from other people.
Money & Banking Session 4 & 5

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.

Money & Banking Session 4 & 5

The Two Types of Money

Commodity Money: something that performs the function of money and has alternative, nonmonetary uses.
Examples: Gold, silver, cigarettes
Money & Banking Session 4 & 5

Fiat Money: something that serves as money but has no other important uses.
Examples: Coins, currency, check deposits

Money in the U.S. Economy

Money Stock is the quantity of money circulating in the economy. Different ways of measuring the money stock in the economy:
Money & Banking Session 4 & 5

M1 M2

Measurement of Money
The most familiar form of money used includes:
Coins Currency Check Deposits Travelers Checks

M1

Measurement of Money
A broader measure of money than M1, includes:
M1 + Savings Deposits + Small Time Deposits + Money Market Mutual Funds + and other minor categories

M2

Where is All The Currency?

In 1996 there was about $380 billion of U.S. currency outstanding ($1,900 in currency per person). Location of outstanding currency may include:
Money & Banking Session 4 & 5

Currency held abroad Currency held by illegal entities Currency held in businesses for transac-tion purposes

The Federal Reserve

The Federal Reserve (Fed) serves as the nations central bank, which is designed to oversee the banking system and regulate the quantity of money in the economy. The Fed is a privately owned institution, authorized in 1914 by Congress to ensure the health of the nations banking system.

Money & Banking Session 4 & 5

The Feds Organization

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.

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Money & Banking Session 4 & 5

The Feds Organization

The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C. and twelve regional Federal Reserve Banks. Monetary policy is made by the Federal Open-Market Committee.
Money & Banking Session 4 & 5

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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 bankers bank, making loans to other banks and as a lender of last resort. Control of the supply of money i.e. Monetary Policy.

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Money & Banking Session 4 & 5

Money Supply Changes by the Fed

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.

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Money & Banking Session 4 & 5

Banks and The Money Supply

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

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Money & Banking Session 4 & 5

Fractional Reserve Banking

Deposits into a bank are recorded as both assets and liabilities. Deposits that have been received but not lent out are called reserves. 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.

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Money & Banking Session 4 & 5

Bank T-Account Example

First National Bank
Assets
Reserves $10.00 Loans $90.00

Liabilities
Deposits $100.00

Total Assets $100.00

Total Liabilities $100.00

Bank T-Account Example

First National Bank
Assets
Reserves $10.00 Loans $90.00

Liabilities
Deposits $100.00

Total Assets $100.00

Total Liabilities $100.00

A T-Account illustrates the financial position of a bank that accepts deposits, keeps a portion as reserves and lends out the rest.

Money Creation with Fractional-Reserve Banking

When a bank makes a loan (from its reserves) the money supply increases. When banks hold only a fraction of deposits in reserve, banks create money. 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.

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Money & Banking Session 4 & 5

The Money Multiplier

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. The Money Multiplier is the amount of money that the banking system generates with each dollar of reserves.

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Money & Banking Session 4 & 5

The Money Multiplier

First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Assets $100.00 Total Liabilities $100.00

Liabilities
Deposits $100.00

The Money Multiplier

First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Assets $100.00 Total Liabilities $100.00

Second National Bank

Assets
Reserves $9.00 Loans $81.00 Total Assets $90.00 Total Liabilities $90.00

Liabilities
Deposits $100.00

Liabilities
Deposits $90.00

The Money Multiplier

First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Assets $100.00 Total Liabilities $100.00

Second National Bank

Assets Liabilities
Reserves Deposits $9.00 $90.00
Loans $81.00 Total AssetsTotal Liabilities $90.00 $90.00

Liabilities
Deposits $100.00

The Money Multiplier

First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Assets $100.00 Total Liabilities $100.00

Second National Bank

Assets
Reserves $9.00

Liabilities
Deposits $100.00

Liabilities
Deposits $90.00

Total Money Supply = $190.00!

Loans
$81.00 Total Assets $90.00 Total Liabilities $90.00

Tools of Monetary Control

The Fed has three instruments of monetary control: Open-Market Operations:
Buying and selling bonds.

Changing the Reserve Ratio:

Increasing or decreasing the ratio. The interest rate the Fed charges other banks for loans.
Money & Banking Session 4 & 5

Changing the Discount Rate:

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Problems in Controlling the Money Supply

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.

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Money & Banking Session 4 & 5