Macroeconomics
CHAPTER 13
Money, Banking, and
the Federal Reserve System
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 the monetary base.
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The Meaning of Money
Money
is any asset that can easily be used to purchase goods
and services.
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.
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Roles of Money
A medium of exchange is an asset that individuals acquire for
the purpose of trading rather than for their own consumption.
A store of value is a means of holding purchasing power over
time.
A unit of account is a measure used to set prices and make
economic calculations.
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Types of Money
Commodity money is a good used as a medium of exchange
that has other uses.
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.
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Money and Banking
Money
1. Why do we have money? There are three basic functions that money serves
a) Medium of exchange
• allows for the specialization of workers. They receive money wages to buy
goods needed rather than produce their own goods.
• avoids the problem of the double coincidence of wants. In a society with barter
you must find someone who has what you desire and wants what you have
produced.
b) Accounting Unit: allows valuation and pricing in a common unit
c) store of value: in barter, need to store goods which could perish or lose value. e.g.
light blue leisure suit with polyester floral print shirt. With money one can store value over
time.
Advantages of money
highly liquid as compared to stocks and bonds.
Disadvantages of money
Loses value during inflationary periods or episodes.
Different Types of Money
a) Commodity Money has value as a commodity such as rice, cattle, seashells, copper,
stones, cigarettes as used in the POW camps of WWII.
problems
• when valuable resources are used as money, those resources cannot be used for
consumption. Copper used to make pennies cannot be used to make electrical
wire.
• There exists an incentive to debase the currency. Rulers would reduce the
amount of the precious metal in a coin. People would tend to circulate the
altered coins and save the coins which still had the greater amount of the
precious metal. This is known as Gresham’s law: bad money drives out good.
• The supply of money is determined by supply of the commodity. The money
supply could fluctuate substantially. The discovery of new gold would mean
that the supply of money would increase and the price level would rise.
b) Fiat Money (has nothing to do with an Italian sports car) very little value as a
commodity money because the public accepts it as money (not necessarily because the
government declares it as money) Peopel accept it because they believe that everyone else
will accept it. This is very different from a “fully backed” currency that is a currency that is
backed by some commodity like gold or silver. For example in the early part of this
century the US still had silver dollar notes. If one wanted one could take the note to the
treasury and demand the silver which was held since the inception of the note as a form of
its backing.
5a
advantages of fiat money
• uses relatively little of society’s resources
• no incentive to debase this type of currency
• supply not tied to commodity. Therefore it potentially has less susceptibility to
lead to fluctuation in the money supply. It can grow with the economy.
•
problem
• government controls money supply and it may cause inflation by printing too
much money
Bank Money: checks backed by a bank account.
in the US we have Fiat and Bank Money
5b
Measuring the Money Supply
A monetary aggregate is an overall measure of the money
supply.
Near-moneys are financial assets that can’t be directly used as
a medium of exchange but can readily be converted into cash or
checkable bank deposits.
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Monetary Aggregates
The Federal Reserve uses three definitions of the money supply:
M1, M2, and M3.
M1 = $1,368.4 (billions of dollars), June 2005
M1 is equally split between
currency in circulation and
checkable bank deposits.
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Monetary Aggregates
The Federal Reserve uses three definitions of the money supply:
M1, M2, and M3.
M2 = $6,510.0 (billions of dollars), June 2005
M2 has a much broader
definition: it includes M1,
plus a range of other
deposits and deposit-like
assets, making it about three
times as large.
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Money Supply Definitions
Most liquid M1 = currency held by the public (not including the banks)
+ demand deposits (non-interest checking accounts)
+ other checkable deposits (interest bearing checking)
+traveller’s checks
Less liquid M2 = M1
+ savings deposits
+ money market mutual fund share, deposits
+ small time deposits
(<$100,000)
+ other
Least liquid M3 = M2
+ large time deposits (>$100,000)
We usually refer to M1 as the money supply.
Credit cards are not money-they are short-term loans which must be paid off using money.
8a
The Monetary Role of Banks
A bank is a financial intermediary that uses liquid assets in
the form of bank deposits to finance the illiquid investments of
borrowers.
Bank reserves are the currency banks hold in their vaults plus
their deposits at the Federal Reserve.
The reserve ratio is the fraction of bank deposits that a bank
holds as reserves.
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Assets and Liabilities of First Street Bank
A T-account summarizes a bank’s financial position. The bank’s
assets, $900,000 in outstanding loans to borrowers and reserves
of $100,000, are entered on the left side. Its liabilities, $1,000,000
in bank deposits held for depositors, are entered on the right side.
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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.
Historically,
they have often proved contagious, with a run on
one bank leading to a loss of faith in other banks, causing
additional bank runs.
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Bank Regulations
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. The FDIC currently guarantees
the first $100,000 of each account.
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Bank Regulations
Capital Requirements - regulators require that the owners of
banks hold substantially more assets than the value of bank
deposits. In practice, banks’ capital is equal to 7% or more of
their assets.
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Bank Regulations
Reserve Requirements - rules set by the Federal Reserve
that determine the minimum reserve ratio for a bank. For
example, in the United States, the minimum reserve ratio for
checkable bank deposits is 10%.
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Determining the Money Supply
Effect on the Money Supply of a Deposit at First Street
Bank - Initial Effect Before Bank Makes New Loans
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Determining the Money Supply
Effect on the Money Supply of a Deposit at First Street
Bank - Effect After Bank Makes New Loans
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How Banks Create Money
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Reserves, Bank Deposits, and the Money
Multiplier
Excess reserves are bank reserves over and above its required
reserves.
Increase in bank deposits from $1,000 in excess reserves =
$1,000 + $1,000 × (1 − rr) + $1,000 × (1 − rr)2 + $1,000
× (1 − rr)3 + . . .
this can be simplified to: Increase in bank deposits from $1,000
in excess reserves = $1,000/rr
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The Money Multiplier in Reality
The
monetary base is the sum of currency in circulation and
bank reserves.
The
money multiplier is the ratio of the money supply to the
monetary base.
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The Federal Reserve System
A
central bank is an institution that oversees and regulates the
banking system and controls the monetary base.
The
Federal Reserve is a central bank—an institution that
oversees and regulates the banking system, and controls the
monetary base.
The
Federal Reserve system consists of the Board of Governors
in Washington, D.C., plus regional Federal Reserve Banks, each
serving its district; of the 12 Federal Reserve districts:
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The Federal Reserve System
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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.
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Open-Market Operations
Open-market operations by the Fed are the principal tool of
monetary policy: the Fed can increase or reduce the monetary
base by buying government debt from banks or selling
government debt to banks.
The Federal Reserve’s Assets and Liabilities:
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Open-Market Operations by the Federal Reserve
An Open-Market Purchase of $100 Million
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Open-Market Operations by the Federal Reserve
An Open-Market Sale of $100 Million
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The End of Chapter 13
coming attraction:
Chapter 14:
Monetary Policy
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