 Federal Reserve, what is money?
 Money is a medium of exchange, a unit of account, and
a store of value.
 As a medium of exchange, money measures value
during the exchange of goods and services.
 As a unit of account, money is a way to compare the
value of goods and services.
 As a store of value. Money holds its value even if it is
not used though inflation affects money.
 The main thing that makes money valuable is the
same thing that generates value for other
commodities:
 The demand for money relative to its supply
 People demand money because it reduces the cost of
exchange
 When the supply of money is limited relative to the
demand, money will be valuable.
 Long ago in some
societies, salt was used as
money. Salt is an
example of commodity
money, it can be used as
money or eaten.
 Commodity money can
be used as money but
also has value in itself.
 Representative money is another type of money.
 An example of representative money is a check
 The paper that the check is written on can be
exchanged for something valuable.
 Fiat money is our money
today.
 Our money is money because
the government states that it
is an acceptable means to pay
debts.
 In other words, its money
because the government says
so.
 “This note is legal tender for
all debts, public and private”
 Do we use pigs as money or paper as money? How does a
society decide?
 There are four physical characteristics of money. Money
should be:
 Portable: small, light and easy to carry
 Divisible: allows for flexible pricing
 Durable: strong enough to last through many transactions
 Uniform: features and markings that make it recognizable and
difficult to counterfeit
 There are three economic characteristics of money:
 Accepted: needs to be accepted as a medium of exchange
 Scarcity: needs to be scarce to maintain value
 Stability of Value: Purchasing power should be relatively stable
 Liquidity: how easy it is to convert money into cash.
 The breakdown measure the money supply by degree
of liquidity.
 Currency: all paper money and coins
 Demand Deposits: Money in a checking account is
called a demand deposit because it can be converted
into currency on demand.
 Near Money: Money is a savings account and other
time deposits. Called near money because it can be
converted into cash with relative ease.
 The US breaks money down in M1 and M2.
 M1:
 Currency
 Demand deposits
 Travelers checks
 M2
 M1
 Savings Accounts
 CDs
 Mutual Funds
 M1 and M2 Explained
near money
 The banking industry includes:
 Savings and loans
 Credit Unions
 Commercial Banks
 Banks are profit-seeking institutions
 Banks accept deposits and use part of them to extend
loans and make investments. This is their major source
of revenue.
 Banks play a central role in the capital market
 They help bring together people who want to save for
the future and those to want to borrow for current
investment projects.
 Banks provide services and pay interest to attract
transactions, and encourage the opening of checking,
savings and CD accounts
 Most of the deposits are invested and loaned out
providing interest income for the bank
 Banks hold a portion of their assets as reserves to meet
their daily obligations toward their depositors.
 The US banking system is a
fractional reserve system
where banks maintain only
a fraction of their assets as
reserves to meet the
requirements of
depositors.
 Under a fractional reserve
system, an increase in
reserves will permit banks
to extend additional loans
and thereby expand the
money supply (by creating
additional checking
deposits)
 The lower the percentage of the reserve requirement,
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the greater the potential expansion in the money
supply resulting from the creation of new reserves.
The fractional reserve requirement places a ceiling on
potential money creation from new reserves.
The actual deposit multiplier will be less than the
potential because:
Some persons will hold currency rather than bank
deposits.
Some banks may not use all their excess reserves to
extend loans.
 History of US Banking
 A bank is an institution for receiving, keeping and
lending money.
 Today, the Federal Reserve Bank oversees all banking
in the United States. But there was a time when banks
were not regulated by the Federal government.
Sometimes bankers made poor decisions that
bankrupted their banks.
 At the founding of the nation, Federalists wanted a
strong, central bank.
 Alexander Hamilton believed that a strong central bank
was essential for the new nation. A strong bank would
prevent abuses in banking
 Anti-Federalists believed that a strong, central bank
would only loan to the rich and powerful.
 Patrick Henry believed that a strong central bank would
have too much power and would favor the rich (exactly
why the Americans rebelled in the first place)
 Eventually the Federalists won and we now have a
strong central bank.
 1791 The First Bank of the United States
 1816-1836 The Second Bank of the United States
 1837-1863 Free Banking or “Wildcat Era”
 Civil War, 1861- Greenbacks
 1870’s Gold Standard is established
 1 oz Gold Equaled about $20
 Limited the amount of notes in circulation
 The Panic of 1907: a severe financial panic jolted Wall
Street and forced several banks into failure. This panic,
however, did not trigger a broad financial collapse. Yet the
simultaneous occurrence of general prosperity with a crisis
in the nation's financial centers persuaded many
Americans that their banking structure was sadly out of
date and in need of major reform.
 Federal Reserve Act of 1913: The Act provided for a Reserve
Bank Organization Committee that would designate no
less than eight but no more than twelve cities to be Federal
Reserve cities, and would then divide the nation into
districts, each district to contain one Federal Reserve City.
 Glass–Steagall Act 1933: reaction to the great depression.
Banks were being too speculative, taking on massive risks
and hoping for big rewards. The act was an attempt to curb
and control bank spending and investments.
 Bank Holding Company Act 1956: further separated
financial activities by creating a wall between insurance
and banking. Even though banks could, and still can, sell
insurance and insurance products, underwriting insurance
was forbidden.
 Gramm-Leach-Bliley Act: repealed part of the GlassSteagall Act. Commercial banks, investment banks,
securities firms, and insurance companies were allowed to
consolidate.
 The deregulation of the banking industry in the 1980’s
ended major restrictions on banks and brought major
changes to how they operate
 Bank Mergers: There have been several of them. Larger
banks with more branches make banking more available
to people
 Expansion of Services: Banks have become like financial
supermarkets. You can get loans, insurance, stocks,
bonds, and more from just one bank.
 history of the FED
 Created by the Federal Reserve Act of 1913: Created a
central bank for the United States which is our nation’s
main monetary authority. Our central Bank is called the
Federal Reserve System, aka THE FED!
 The Duties of the Fed
 Regulation and Oversight: make sure that banks are following
sound practices and are not defrauding customers
 The Banker’s Bank: lends $ and provides other banking
services for private banks and the national government
 Times of Emergency: Financed involvement in WWI and lent
$45 billion after 9/11 to minimize the disruption to the
banking system
 Distributes Currency: Issues currency and regulates the
supply of money.
 The Board of Governors of the Federal Reserve is at the center of the
banking system in the U.S.
 The board sets all the rates and regulations for all depository institutions.
 7 members, appointed to 14-year terms. Appointed by President and
approved by senate. Serve only 1 term.
 Every 4 years the president chooses a chairman from the board. (Janet
Yellen)
 The FOMC is a 12-member board that establishes Fed policy
regarding the buying and selling of government securities. The 12
members are the seven members of the Board of Governors; the
president of the Federal Reserve Bank of New York; and four of the
remaining eleven Reserve Bank presidents, who serve one-year terms
on a rotating basis.
 FOMC meets 8 times a year to review economic & financial
conditions, make recommendations on changes in monetary policy
and monitor growth.
 Advisory Councils: The Fed has several advisory councils that advise
the FED on the specific needs of various segments of financial
institutions.
 The Federal Reserve controls the three tools of
monetary policy: open market operations, the discount
rate, and reserve requirements. The board of
Governors is responsible for the discount rate and the
reserve requirements and the FOMC is responsible for
open market operations.
 Reserve requirements: The minimum percentage of
deposits that banks must keep on reserve to back up
checking type accounts
 When the Fed lowers the required reserve ratio, it
creates excess reserves for commercial banks allowing
them to extend additional loans, expanding the money
supply.
 Raising the reserve requirements means banks have
less money to lend and the money supply decreases.
 Open Market Operations: the buying and selling of
U.S. securities (in the form of bonds) by the Fed.
 This is the primary tool used by the Fed.
 Fed buys bonds – the money supply expands:
 bond buyers acquire money
 bank reserves increase, placing banks in a position to expand
the money supply through the extension of additional loans.
 Fed sells bonds – the money supply contracts:
 bond buyers give up money for securities
 bank reserves decline, causing them to extend fewer loans.
 Discount Rate: the interest rate the Fed charges banking
institutions for borrowed funds (loans). Banks whose
reserves dip below the reserve requirement set by the
Federal Reserve's board of governors use that money to
correct their shortage. The board of directors of each
reserve bank sets the discount rate every 14 days.
 An increase in the discount rate decreases the money
supply (restrictive) because it discourages banks from
borrowing from the Federal Reserve to extend new loans.
 A reduction in the discount rate increases the money
supply (expansionary) because it makes borrowing from
the Federal Reserve less costly.
 Cash on Hand: Holiday season, natural disasters, etc.
During these times the Fed will increase the amount of
cash at banks
 Interest rates: When rates are high, people will place more
cash in savings instruments and the demand for money is
low because there is less incentive to spend and more
incentive to save and earn interest. Opposite when rates are
low.
 Cost of Consumer Goods and Services: as the cost of goods
and services increases, buyers may wish to have more
money available to them
 Level of Income: As income increases people have a
tendency to hold more cash.
 The Federal Reserve:
 The U.S. Treasury:
 Is concerned with the
 Is concerned with the
monetary climate for the
economy.
 Does not issue bonds.
 Determines the money
supply — primarily
through its buying and
selling of bonds issued
by the U.S. Treasury.
finance of the federal
government.
 Issues bonds to the
general public to finance
the budget deficits of the
federal government.
 Does not determine the
money supply.
 Expansionary Monetary
Policy (easy-money
policy)
 Contractionary
Monetary Policy (Tightmoney policy)
 When the FED tries to
 When the Fed tries to
increase the amount of
money in circulation
reduce the amount of
money in circulation
 Short Term Effects: immediate increases or decreases on
interest rates, lending, and money supply
 Policy Lags: It may be hard to identify the economic
problem when it is time to implement the policy
 Timing Issues: Policies need to be implemented in the
right time during the business cycle.
 Monetarism: theory that rapid changes in money supply
actually cause economic instability. They prefer slow, steady
growth and dislike when the FED tinkers with rates to get the
$ supply up quickly.
 Other Issues: The fed is independent of president and
congress and they may not all always agree on monetary
policy.