CHAPTER 30 Money, Banking, and the Federal Reserve System PowerPoint® Slides by Can Erbil © 2005 Worth Publishers, all rights reserved 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. 2 Roles of Money A medium of exchange An asset that individuals acquire for the purpose of trading rather than for their own consumption. A store of value Holds purchasing power over time. A unit of account Measure used to set prices and make economic calculations 3 Types of Money Commodity money A commodity-backed money Fiat money 4 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. 5 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 includes M1, plus a range of other deposits and deposit-like assets, making it about three times as large. 6 The Monetary Role of Banks A bank is a financial intermediary. 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. 7 Bank Regulations Deposit insurance Capital requirements Reserve requirements 8 Determining the Money Supply Effect on the Money Supply of a Deposit at First Street Bank 9 How Banks Create Money 10 Reserves, Bank Deposits, and the Money Multiplier 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 11 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. 12 The Federal Reserve System Board of Governors = 7 members appointed by the President and approved by the Senate . Each member serves a 14 year term. The chairman serves 4 year terms, but traditionally they are reappointed. New York Fed carries out open-market operations, the Fed’s main monetary policy. Decisions about monetary policy are made by the Federal Open Market Committee (FOMC) FOMC = The Board of Governors plus five regional Fed Presidents on a rotating basis with the exception of the President of the New York Fed who is a permanent member. 13 What the Fed Does: Reserve Requirements and the Discount Rate The federal funds market Financial market that allows banks that fall short of the reserve requirement to borrow reserves – usually just overnight – from banks that hold excess reserves. The federal funds rate Interest rate that banks charge for lending overnight to another bank. Determined by supply and demand, but strongly affected by the Federal Reserves actions The discount rate The rate of interest the Fed charges on loans to banks. 1% point above the federal funds rate. 14 Open-Market Operations The Federal Reserve’s Assets and Liabilities: 15 Open-Market Operations by the Federal Reserve An Open-Market Purchase of $100 Million 16 Open-Market Operations by the Federal Reserve An Open-Market Sale of $100 Million 17 The End of Chapter 13 coming attraction: Chapter 14: Monetary Policy 18