Economics: Private & Public Choice | Part 3: Core Macroeconomics | Chapter 13: Money and the Banking System
What Is Money?
A. Money is the item commonly used to pay for goods, services, assets, and outstanding debts.
B. Money as a Medium of Exchange
1. Medium of Exchange - An asset that is used to buy and sell goods or services.
2. Fiat Money - Money that has neither intrinsic value nor the backing of a commodity with intrinsic
value; paper currency is an example.
C. Money as a Store of Value
1. Liquid - An asset that can be easily and quickly converted to money without loss of value.
2. Store of Value - An asset that will allow people to transfer purchasing power from one period to the
next.
D. Money as a Unit of Account
1. Unit of Account - A unit of measurement used by people to post prices and keep track of revenues
and costs.
II.
How the Supply of Money Affects Its Value
III.
How Is the Money Supply Measured?
A. The M1 Money Supply
1. M1 - The sum of (1) currency in circulation (including coins), (2) checkable deposits maintained in
depository institutions, and (3) traveler's checks.
2. Currency - Medium of exchange made of metal or paper.
3. Demand Deposits - Non-interest-earning checking deposits that can be either withdrawn or made
payable on demand to a third party. Like currency, these deposits are widely used as a means of
payment.
4. Other Checkable Deposits - Interest-earning deposits that are also available for checking.
5. Thus, the M1 money supply comprises (1) currency in circulation, (2) checkable deposits (both
demand deposits and interest-earning checkable deposits), and (3) traveler's checks.
I.
6.
IV.
B. The Broader M2 Money Supply
1. M2 - Equal to M1 plus (1) savings deposits, (2) time deposits (accounts of less than $100,000) held in
depository institutions, and (3) money market mutual fund shares.
2. Depository Institutions - Businesses that accept checking and savings deposits and use a portion of
them to extend loans and make investments. Banks, savings and loan associations, and credit unions
are examples.
3. 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 share holdings) against their accounts.
C. Credit Cards versus Money
1. Credit - Funds acquired by borrowing.
The Business of Banking
A. Federal Reserve System - The central bank of the United States; it carries out banking regulatory policies
and is responsible for the conduct of monetary policy.
Economics: Private & Public Choice | Part 3: Core Macroeconomics | Chapter 13: Money and the Banking System
B. Central Bank - An institution that regulates the banking system and controls the supply of a country's
money.
C. Savings and Loan Associations - Financial institutions that accept deposits in exchange for shares that pay
dividends. Historically, these funds were channeled into residential mortgage loans, but today they offer
essentially the same services as a commercial bank.
D. Credit Unions - Financial cooperative organizations of individuals with a common affiliation (such as an
employer or a labor union). They accept deposits, including checkable deposits, pay interest (or dividends)
on them out of earnings, and lend funds primarily to members.
E. Commercial Banks - Financial institutions that offer a wide range of services (for example, checking
accounts, savings accounts, and loans) to their customers. Commercial banks are owned by stockholders
and seek to operate at a profit.
F. Therefore, when we speak of the banking industry, we are referring not only to commercial banks but also
to savings and loan associations and credit unions.
G.
V.
H. Bank Reserves - Vault cash plus deposits of banks with Federal Reserve banks.
I. Fractional Reserve Banking
1. Fractional Reserve Banking - A system that permits banks to hold reserves of less than 100% against
their deposits.
2. Required Reserves - The minimum amount of reserves that a bank is required by law to keep on hand
to back up its deposits. If reserve requirements were 15%, banks would be required to keep $150,000
in reserves against each $1 million of deposits.
J. Bank Runs, Bank Failures, and Deposit Insurance
1. Federal Deposit Insurance Corporation (FDIC) - A federally chartered corporation that insures the
deposits held by commercial banks, savings and loans, and credit unions.
How Banks Create Money by Extending Loans
A. Required Reserve Ratio - The ratio of reserves relative to a specified liability category (for example,
checkable deposits) that banks are required to maintain.
B. Excess Reserves - Actual reserves that exceed the legal requirement.
Economics: Private & Public Choice | Part 3: Core Macroeconomics | Chapter 13: Money and the Banking System
C.
VI.
D. Deposit Expansion Multiplier - The multiple by which an increase in reserves will increase the money supply.
It is inversely related to the required reserve ratio.
E. Potential Deposit Expansion Multiplier - The maximum potential increase in the money supply as a ratio of
the new reserves injected into the banking system. It is equal to the inverse of the required reserve ratio.
F. The lower the percentage of reserves required, the larger the potential expansion in the money supply
generated by creation of new reserves. However, the fractional reserve requirement puts a ceiling on the
expansion in the money supply resulting from the creation of new reserves.
G. The Actual Deposit Multiplier
1. First, the deposit expansion multiplier will be reduced if some people decide to hold the currency
rather than deposit it in a bank.
2. Second, the actual deposit multiplier will be less than its maximum potential if banks fail to use all the
new excess reserves to extend loans.
The Federal Reserve System
A. Structure of the Fed
1.
2. The Board of Governors
3. The Federal Reserve District Banks
Economics: Private & Public Choice | Part 3: Core Macroeconomics | Chapter 13: Money and the Banking System
a.
4. The Federal Open Market Committee
a. Federal Open Market Committee (FOMC) - A committee of the Federal Reserve system that
establishes Fed policy with regard to the buying and selling of government securities--the
primary mechanism used to control the money supply. It is composed of the seven members of
the Board of Governors and the twelve district bank presidents of the Fed.
5. The Independence of the Fed
B. How the Fed Controls the Money Supply
1. (1) the establishment of reserve requirements for banks, (2) buying and selling US government
securities and other financial assets in the open market, (3) the volume of loans extended to banks
and other institutions, and (4) the interest rate it pays banks on funds held as reserves.
2. Reserve Requirements
a.
b. An increase in the reserve requirements will reduce the supply of money.
3. Open Market Operations
a. Open Market Operations - The buying and selling of US government securities and other
financial assets in the open market by the Federal Reserve.
b. When the Fed buys things, it injects "new money" into the economy in the form of additional
currency in circulation and deposits with commercial banks .In essence, the Fed creates money
out of nothing.
c. If the Fed wants to reduce the money supply, it sells some of its current holdings of government
securities or other assets.
4. Extension of Loans by the Fed
a. Discount Rate - The interest rate the Federal Reserve charges banking institutions for shortterm loans.
Economics: Private & Public Choice | Part 3: Core Macroeconomics | Chapter 13: Money and the Banking System
b. Federal Funds Market - A loanable funds market in which banks seeking additional reserves
borrow short-term funds (generally for seven days or less) from banks with excess reserves. The
interest rate in this market is called the federal funds rate.
c. Term Auction Facility (TAF) - Newly established procedure used by the Fed to auction credit for
an eighty-four-day period to depository institutions willing to bid the highest interest rates for
the funds.
5. Interest Rate the Fed Pays Banks on Reserves
6. Controlling the Money Supply - A Summary
a.
C. Recent Fed Policy, the Monetary Base, and the Money Supply
1.
2. Monetary base - The sum of currency in circulation plus bank reserves (vault cash and reserves with
the Fed). It reflects the purchases of financial assets and extension of loans by the Fed.
Economics: Private & Public Choice | Part 3: Core Macroeconomics | Chapter 13: Money and the Banking System
3.
VII.
D. The Fed and the Treasury
Ambiguities in the Meaning and Measurement of the Money Supply
A.
B. Widespread Use of the US Dollar Outside of the United States
C. The Increasing Availability of Low-Fee Stock and Bond Mutual Funds
D. Substitution of Electronic Payments For Checks and Cash