Chapter

The Monetary System

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The Meaning of Money

• Money– Set of assets in an economy used to buy

goods/services from others• The functions of money

– Medium of exchange– Unit of account– Store of value

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The Meaning of Money

• Medium of exchange– Item that buyers give to sellers for purchases

• Unit of account– Yardstick used to post prices and record debts

• Store of value– Used to transfer purchasing power from

present to future• Liquidity

– Ease with which an asset can be converted into the economy’s medium of exchange

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Types of Money

• Commodity money– Money that takes the form of a commodity

with intrinsic value (e.g., gold)• Item would have value even if it were not used as

money

• Fiat money– Money without intrinsic value (currency)

• Used as money because of government decree

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The Meaning of Money

• Money in the U.S. economy– Currency– Paper bills and coins in the hands of the public

• Demand deposits– Balances in bank accounts

• Depositors can access on demand by writing a check

• Measures of money stock– M1, M2

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Figure

Two measures of the money stock for U.S. economy

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6The two most widely followed measures of the money stock are M1 and M2. This figure shows the size of each measure in 2007

• 2007: $759 billion of currency outstanding– Average adult: holds about $3,272 of currency– Where is it all? Maybe ….

• Much of the currency is held abroad• Much of the currency is held by drug dealers, tax evaders,

and other criminals

• Currency – not a particularly good way to hold wealth– Can be lost or stolen– Doesn’t earn interest

• Transaction demand? With debit cards –really?

Where is all the currency?

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The Federal Reserve System

• Federal Reserve (Fed)– The central bank of the United States

• Central bank– Institution designed to

• Oversee the banking system• Regulate the quantity of money in the economy

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The Federal Reserve System

• The Fed’s organization– Created in 1913– Board of governors

• 7 members– Appointed by the president & confirmed by the Senate– Have 14-year terms

• The chairman (Janet Yellen )– Directs the Fed staff– Presides over board meetings– Testifies regularly about Fed policy in front of

congressional committees.– Appointed by the president (4-year term)

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The Federal Reserve System

• The Fed’s organization• The Federal Reserve System

– Federal Reserve Board in Washington, D.C.– 12 regional Federal Reserve Banks

• Major cities around the country• The presidents - chosen by each bank’s board of

directors

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The Federal Reserve System

• The Fed’s jobs– Regulate banks & ensure the health of the

banking system (risk assessment)• Legislated by Congress• Do the banks hold enough cash to withstand

another financial bubble, or are they “investing” too much in too many risky assets? (Stress Test)

– Conduct Expansionary/Contractory/neutral monetary policy

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The Federal Reserve System

Fed’s role in conducting Monetary Policy –Control the money supply

• Buying (contractive)/selling (expanding) of bonds

–Set the Federal Discount Rate• Affects market interest rates

– Rate at which member banks can borrow from the Fed

–Set the Reserve Requirement• % of assets held as cash by member banks• Affects the Money Multiplier

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The Federal Reserve System

• The Fed’s jobs– Control the money supply

• Quantity of money available in the economy

– Monetary policy– Setting of the money supply by policymakers in the central

bank

• Federal Open Market Committee (FOMC)– 7 members of the board of governors– 5 of the twelve regional bank presidents– Meets about every six weeks in Washington, D.C.– Discuss the condition of the economy– Consider changes in monetary policy

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The Federal Reserve System

• Fed’s primary tool - open-market operation– Purchase & sale of U.S. government bonds

• FOMC - increase the money supply– The Fed: open-market purchase of

outstanding t-bills, bonds (corporate)• Increases the money supply

• FOMC - decrease the money supply– The Fed: open-market sale of t-bills

• Decreases the money supply

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Banks and the Money Supply

• Reserves – Deposits that banks have received but have

not loaned out• The simple case of 100% reserve banking• All deposits are held as reserves

– Banks have no influence the supply of money

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FIRST NATIONAL BANKAssets Liabilities

Reserves $100.00 Deposits $100.00

Banks and the Money Supply

• Money creation: fractional reserve banking– Banking system– Banks hold only a fraction of deposits as

reserves – lend remainder out – Reserve ratio

• Fraction of deposits that banks hold as reserves

• Reserve requirement – minimum % of assests held as cash that bank must hold –– Minimum set by the Fed (10%)– Bank may hold additional excess reserves

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Banks and the Money Supply

• Money creation: fractional reserve banking– Reserve ratio = 1/10 (10 percent, R)

• Banks hold only a fraction of deposits in reserve– Banks create “additional” money– Increases in money supply > Fed injection

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FIRST NATIONAL BANKAssets Liabilities

Reserves Loans

$10.00$90.00

Deposits $100.00

Banks and the Money Supply

• The money multiplier

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SECOND NATIONAL BANKAssets Liabilities

Reserves Loans

$9.00$81.00

Deposits $90.00

THIRD NATIONAL BANKAssets Liabilities

Reserves Loans

$8.10$72.90

Deposits $81.00

Banks and the Money Supply

• The money multiplier• Original deposit = $100.00• First National lending = $ 90.00 [= .9 × $100.00]• Second National lending = $ 81.00 [= .9 × $90.00]• Third National lending = $ 72.90 [= .9 × $81.00]• …• Total money supply = $1,000.00

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Banks and the Money Supply

• The money multiplier– Amount of money the banking system

generates with each dollar of reserves– Reciprocal of the reserve ratio = 1/R

• Max for money multiplier• Assumes banks hold only minimum R

• The higher the reserve ratio– The smaller the money multiplier

• Recent requirement from stress test for more risky investments

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Banks and the Money Supply

• The Fed’s tools of monetary control1.Open-market operations

– Purchase and sale of U.S. government bonds by the Fed (to public and domestic/foreign investors)

– To increase the money supply• The Fed buys U.S. government bonds

– To reduce the money supply• The Fed sells U.S. government bonds

– This is the Fed’s preferred tool21

Current Fed Policy

• Quantitative easing (QE) – unconventional monetary policy to stimulate

the economy when standard monetary policy has become ineffective

– implemented by buying financial assets from commercial banks and other private institutions, • Raises prices of those financial assets and

lowering their yield, while simultaneously increasing the monetary base.[4][5]

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Traditional Fed Policy• QE differs from is more usual policy of buying or selling short

term government bonds in order to keep interbank interest rates at a specified target value

• Expansionary monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates.[10][11][12][13] However, when short-term interest rates have reached or are close to reaching zero, this method can no longer work.[14] Quantitative easing may then be used by monetary authorities to further stimulate the economy by purchasing assets of longer maturity than short-term government bonds, and thereby lowering longer-term interest rates further out on the yield curve.[15][16]

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Banks and the Money Supply

• The Fed’s tools of monetary control2.Reserve requirements

– Regulations on minimum amount of reserves• That banks must hold against deposits

– An increase in reserve requirement• Decrease the money supply

– A decrease in reserve requirement• Increase the money supply

– Used rarely – disrupt business of banking

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Banks and the Money Supply

• The Fed’s tools of monetary control3.The discount rate

– Interest rate on the loans that the Fed makes to banks

– Higher discount rate• Reduce the money supply

– Smaller discount rate• Increase the money supply

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Banks and the Money Supply

• Problems in controlling the money supply• The Fed

– Does not directly control the amount of money in circulation (M1 or M2)

– Households choose to portion of wealth held as deposits in banks and portion held as cash/ demand deposit

• The Fed– Does not control the amount portion of

assets bankers choose to lend26

• Bank runs– Depositors suspect that a bank may go bankrupt

• “Run” to the bank to withdraw their deposits

– Problem for banks under fractional-reserve banking• Cannot satisfy withdrawal requests from all depositors

– When a bank run occurs• The bank - is forced to close its doors• Until some bank loans are repaid• Or until some lender of last resort provides it with the

currency it needs to satisfy depositors

– Complicates the “exact” control of the money supply

Bank runs and the money supply

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• Great Depression, early 1930s– Wave of bank runs and bank closings– Households and bankers - became more cautious– Households

• Withdrew their deposits from banks• Hold their money – currency

– Bankers - responded to falling reserves• Reducing bank loans• Increased their reserve ratios• Smaller money multiplier• Decrease in money supply

Bank runs and the money supply

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• Bank runs today - not a major problem• The federal government

– Guarantees the safety of deposits at most banks• Federal Deposit Insurance Corporation (FDIC)

• No bank runs– Depositors are confident– FDIC will make good on the deposits

• Government deposit insurance– Cost: Bankers - little incentive to avoid bad risks – Benefit: a more stable banking system

Bank runs and the money supply

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Banks and the Money Supply

• The federal funds rate– Interest rate at which banks make overnight

loans to one another– A change in federal funds rate

• Changes other interest rates

– Can be targeted by the Fed• Open-market operations

– The Fed buys – decrease in federal funds rate» Increase in money supply

– The Fed sells – increase in federal funds rate» Decrease in money supply

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