ECO 2013 Topic 4 Money - is the set of assets in the economy that people regularly use to buy goods and services from other people. Functions of Money Money has three functions 1. Medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. It also society to escape the complications of barter. 2. Unit of Account - the yardstick people use to post prices and record debts. 3. Store of value - an item that people can use to transfer purchasing power from the present to the future. When a seller accepts money today in exchange for a good or service, that seller can hold the money and become a buyer of another good or service at another time. A person can also transfer purchasing power from the present to the future by holding stocks, bonds, real estate, etc. The term wealth is used to refer to the total of all stores of value. Liquidity to describe the ease with which an asset can be converted into the economy’s medium of exchange. The Supply of Money Money Definitions o M1 – it consists of currency and checkable deposits o M2 – M1 + savings deposits + money market deposits + small time deposits(less than $100,000) + money market mutual funds Called near money o M3 – M2+ large time deposits Created by: Prof. M. Mari Fall, 1999 1 ECO 2013 Topic 4 Kinds of Money Commodity money - money that takes the form of a commodity with intrinsic value. Gold Standard - when an economy uses gold as money. Fiat money - money without intrinsic value that is used as money because of government decree. Government is central to establishing and regulating a system of fiat money. The acceptance of fiat money depends as much on expectations and social convention as on government decree. Value of Money Our money has value because: Acceptability Legal tender Relative scarcity Demand for Money Transactions Demand o Medium of exchange function o Main determinant of the amount of money demanded for transactions is the level of nominal GDP. Asset Demand o Store of value function o Holding of financial assets o Depends on bond interest rate Total Demand o Sum of the above Created by: Prof. M. Mari Fall, 1999 2 ECO 2013 Topic 4 The Federal Reserve Board of Governors Directs the activities of the 12 Federal Reserve Banks Seven members appointed by the president and confirmed by the Senate. Terms of 14 years and staggered Officers serve 4-year terms Chairman is Alan Greenspan Federal Open Market Committee - is made up of seven members of the Board of Governors and 5 of the 12 regional bank presidents meets every six weeks in Washington, DC to discuss the condition of the economy and consider changes in monetary policy Power to increase or decrease the number of dollars in the economy. If the FOMC decides to increase the money supply, the Fed creates dollars and uses them to buy government bonds from the public in the nation’s bond markets. If the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. Three Advisory Councils: 1. Federal Advisory Council 2. Thrift Institution Council 3. Consumer Advisory Council Federal Reserve Banks 12 district banks serves as central banks called banker’s bank owned by local commercial banks in its district Created by: Prof. M. Mari Fall, 1999 3 ECO 2013 Topic 4 Performs the same functions for banks and thrifts as those institutions perform for the public. Functions i. Issuing currency ii. Setting reserve requirements and holding reserves iii. Lending money to banks and thrifts iv. Providing for check collection v. Acting as fiscal agent for the government vi. Supervising banks vii. Controlling the money supply viii. Independent agency Banks and the Money Supply Reserves - deposits that banks have received but have not loaned out. Fractional-reserves banking - a banking system in which banks hold only a fraction of deposits as reserves. Reserve ratio - the fraction of deposits that banks hold as reserves. When banks hold only a fraction of deposits in reserve, banks create money. Money Multiplier - the amount of money the banking system generates with each dollar of reserves. Reciprocal of the reserve ratio The Fed.’s Tools of Monetary Control Open Market Operations The purchase and sale of US government bonds by the Fed Increase the money supply - buy bonds Decrease the money supply - sell bonds Created by: Prof. M. Mari Fall, 1999 4 ECO 2013 Topic 4 Reserve Requirements Also influences the money supply with reserve requirements which are regulations on the minimum amount of reserves that bank must hold against deposits. Increase in reserve requirements means that banks must hold more reserves and can loan out less of each dollars that is deposited. Decrease in reserve requirement lowers the reserve ratio, raises the money multiplier and increases the money supply. Used infrequently because it would disrupt the business of banking. Discount rate The interest rate on the loans that the Fed makes to banks Increase the discount rate discourages banks from borrowing reserves from the Fed. Decrease the discount rate encourages banks to borrow from the Fed. Easy Money Policy Increasing the money supply Buy securities Lower the reserve requirements Lower the discount rate Called expansionary monetary policy Tight Money Policy Decreasing the money supply Sell securities Raise the reserve requirements Raise the discount rate Called restrictive monetary policy Created by: Prof. M. Mari Fall, 1999 5