Ch 13
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Recite the three functions of money and
recognize which function is being illustrated
List the and describe the items included in
M1 and M2
Outline the structure of the Fed
Solve answers to mathematical problems
about banks’ creation of money
List the tools used by the Fed to control the
economy
Money is whatever is generally accepted in
exchange for goods and services – accepted
not as an object to be consumed but as an
object that represents a temporary abode of
purchasing power to be used for buying still
other goods and services.
--Milton Friedman
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You can buy something with it
You can save it
You can compare values and cost
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These are the three functions of money
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Medium of exchange – an asset that is used
to buy and sell goods or services
Without a medium of exchange, barter
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When you use $5 cash to pay for a foot-long
Commodities are often inconvenient
mediums of exchange
◦ Examples: gold, silver, cigarettes
◦ Heavy, dangerous, uncertain purity levels
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Store of Value – an item people can use to
transfer purchasing power from the present
to the future
When you put money aside each month to
save for spring break
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Liquid Asset – can be easily converted into
money w/o loss of value
Houses are a store of value, not liquid
Bonds are liquid, not mediums of exchange
Currency and checking accounts are liquid
and mediums of exchange
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Inflation reduces money value
Causes money to cease being a store of value
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Unit of account – the unit of measurement
people use to post prices and keep track of
revenues and costs
When you use dollar prices to compare costs
$5
$5
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Money that has neither intrinsic value nor the
backing of a commodity with intrinsic value
Paper currency of most countries
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Fiat money has value because of
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◦ We trust that it’s valuable
◦ It is scarce
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M1 – the sum of currency, checkable
deposits, travelers checks
Demand deposits – non-interest earning
checking deposits that depositors can access
by writing a check (or using debit card)
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M2 – includes M1 plus savings deposits, time
deposits less than $100,000, and money
market mutual fund shares
Money market mutual funds – interest
earning accounts that pool depositors funds
and invest them in highly liquid short-term
securities. Because these securities can be
quickly converted to cash, depositors are
permitted to write checks (which reduce their
shareholdings) against their accounts
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Credit
◦ Funds acquired by borrowing
◦ A liability
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Money is an asset
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Match borrowers with savers
Profitable projects promote economic growth
Banking system includes savings and loan
associations, credit unions, commercial banks
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Institution designed to oversee the banking
system and regulate the amount of money in
the economy.
U.S. central bank is the Federal Reserve
System (The Fed)
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Liabilities: deposits, borrowings
Assets: vault cash, securities, loans
Liabilities are payable on demand!
Bank reserves – vault cash plus deposits of
banks with Federal Reserve banks
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Fractional reserve banking – allows banks to
hold reserves of less than 100% against
deposits
Required reserves – the minimum amount
that a bank is required to keep on had to
back up deposits
Fractional reserve banking increases the
money supply
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Guarantees deposits up to $250,000
Failures
◦ 10,000 during Great Depression
◦ 200 during most recent recession
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Pros: no more bank runs
Cons: no incentive for depositors to monitor
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Required reserve ratio – the ratio of reserves
that banks are required to maintain in their
vaults
Excess reserves – actual reserves that exceed
the legal requirement
Deposit expansion multiplier
◦ maximum potential increase in the money supply as
new reserves are injected
1
𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑒𝑥𝑝𝑎𝑛𝑠𝑖𝑜𝑛 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑎𝑡𝑖𝑜
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Actual deposit multiplier will be smaller than
the potential because
◦ Some people hold currency.
◦ Banks hold excess reserves.
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Monetary policy – control of the money
supply by the Fed
Expansionary monetary policy – increasing
the money supply
Restrictive monetary policy – decreasing the
money supply
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1. Change reserve requirements
2. *Open market operations* (buying and
selling gov’t securities and other financial
assets)
3. Extend loans to banks and other
institutions
4. Change interest rate on funds held as
reserves
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Lowering the reserve requirement increases
the money supply
Increasing the reserve requirement decreases
the money supply
Crisis of 2008
◦ Before: most banks held very little excess reserves
◦ After: banks hold excess reserves
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Open market operations – buying and selling
of U.S. securities (bonds) and other financial
assets
◦ Buying bonds increases the money supply
◦ Selling bonds decreases the money supply
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Crisis of 2008
◦ Before: Only U.S. treasury securities
◦ After: Corporate bonds, commercial paper,
mortgage-backed securities
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Discount rate
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Federal funds rate
◦ The interest rate the Fed charges banks for loans
◦ Usually short term – days /weeks
◦ The interest rate that banks charge banks for loans
◦ Usually short term – days /weeks
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Lowering these interest rates increases the money supply
Increasing these interest rates decreases the money supply
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Crisis of 2008
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◦ Before: Only short-term discount rate loans to member banks
◦ After: longer-term loans to other companies (insurance,
brokerage)
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Lowering the interest payments on reserves
held at the Fed increases the money supply
Increasing the interest payments on reserves
held at the Fed decreases the money supply
Crisis of 2008
◦ Before: Fed did not pay interest on reserves
◦ After: Fed has been paying rate about equal to
federal funds rate
Policy
Expansionary
Monetary Policy
Restrictive Monetary
Policy
Reserve requirements
Lower
Increase
Open market
operations
Buy bonds and other
assets
Sell bonds and other
assets
Extend loans
More loans,
Lower discount rate
Fewer loans,
Increase discount rate
Pay interest on excess
bank reserves
Lower interest
payments
Increase interest
payments
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2008: QE1
◦ Assets rise from $923 billion to $2.1 trillion
◦ Fed buys mortgage-backed securities
◦ Extends loans
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2010: QE2
◦ Assets rise to $2.9 trillion
◦ Fed buys treasury securities
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2012: QE3
◦ Assets rise to $3.4 trillion
◦ Fed buys treasury and mortgage-backed securities
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Monetary base = currency + bank reserves
1990 – 2007
◦ Monetary base approximately equal currency + required
reserves
◦ Excess reserves are near zero
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2008 and beyond
◦ Monetary base grows rapidly
◦ Money supply grows more slowly than monetary base
◦ Because banks increase excess reserves
 Banks don’t want to give risky loans
 Demand for low-risk loans is weak
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If banks reduce excess reserves and Fed does
not reduce monetary base, high inflation will
occur
The Fed
The Treasury
Issue Bonds?
No
Yes
Buy/sell bonds?
Buys and sells bonds to
control the money
supply
Sells bonds to finance
government budget
deficits
Control the money Yes
supply?
No
Objective?
Controlling the money
supply
Financing government
deficits
Create money?
Creates money out of
thin air by writing a
check on itself
No
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Recite the three functions of money and
recognize which function is being illustrated
List the and describe the items included in
M1 and M2
Outline the structure of the Fed
Solve answers to mathematical problems
about banks’ creation of money
List the tools used by the Fed to control the
economy