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The Monetary System

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The Meaning of Money

Money is the set of assets in the economy that

people regularly use to buy goods and services

from other people.

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Three Functions of Money

Medium of Exchange: anything that is readily acceptable as

payment.

Unit of Account: serves as a unit of account to help us

compare the relative values of goods.

Store of Value: a way to keep some of our wealth in a readilyspendable form for future needs.

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The Two Types of Money

Commodity Money: something that performs the function of money

and has alternative, nonmonetary uses.

Examples: Gold, silver, cigarettes

Fiat Money: something that serves as money but has no other

important uses.

Examples: Coins, currency, check deposits

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Money in the U.S. Economy

Money Stock is the quantity of money circulating in the

economy.

Different ways of measuring the money stock in the economy:

M1 M2

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Measurement of Money

The most familiar form of money usedincludes:

Coins

Currency

Check Deposits Travelers Checks M

1

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Measurement of Money

A broader measure of money than M1,includes: M1 +

Savings Deposits +

Small Time Deposits +

Money Market Mutual Funds +

and other minor categories M2

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Where is All The Currency?

In 1996 there was about $380 billion of U.S. currency

outstanding ($1,900 in currency per person).

Location of outstanding currency may include:

Currency held abroad

Currency held by illegal entities

Currency held in businesses for transac-tion purposes

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The Federal Reserve

The Federal Reserve (Fed) serves as the nations central

bank, which is designed to oversee the banking system and

regulate the quantity of money in the economy.

The Fed is a privately owned institution, authorized in 1914

by Congress to ensure the health of the nations bankingsystem.

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The Feds Organization

The Fed is run by its Board of Governors.

Seven members appointed by the President of the United States.

The Chairman of the Board is the most important position:

presiding, directing, and testifying about Fed policy. She/He is

appointed by the President.

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The Feds Organization

The Federal Reserve System is made up of the Federal Reserve Board in

Washington, D.C. and twelve regional Federal Reserve Banks.

Monetary policy is made by the Federal Open-Market Committee.

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Three Primary Functions of the

FedRegulate the private banking industry to make sure banks follow

federal laws intended to promote safe and sound banking practices.

Act as a bankers bank, making loans to other banks and as a lender

of last resort.

Control of the supply of money i.e. Monetary Policy.

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Money Supply Changes by the Fed

Open-Market Operations: The primary way in which the Fed

changes the money supply done through the purchase and sale

of U.S. government bonds with newly printed money.

To increase the money supply, the Fed buys government bonds from

the public.

To decrease the money supply, the Fed sells government bonds to

the public.

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Banks and The Money Supply

The behavior of banks can influence the quantity of demand

deposits in the economy and therefore, the money supply.

Fractional Reserve Banking System: The practice of holding a

fraction of money deposited as reserves and lending out the

rest.

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Fractional Reserve Banking

Deposits into a bank are recorded as both assets and

liabilities. Deposits that have been received but not lent out

are called reserves.

The supply of money in the economy is affected by the

amount of deposits that are kept in the bank as reserves andthe amount that is lent out. Loans become an asset to the

bank.

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Bank T-Account Example

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

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Bank T-Account Example

A T-Account

illustrates the

financial position of a

bank that acceptsdeposits, keeps a

portion as reserves

and lends out therest.

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

M C i i h

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Money Creation with

Fractional-Reserve Banking

When a bank makes a loan (from its reserves) the money supply

increases. When banks hold only a fraction of deposits in reserve,

banks create money.

The creation of money through loans does not create any wealth,

but allows banks to charge interest several times on the same bit

of wealth.

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The Money Multiplier

When one bank loans money, that money is generally

deposited into another or the same bank thus creating more

deposits and more reserves to be lent out.

The Money Multiplieris the amount of money that the

banking system generates with each dollar of reserves.

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The Money Multiplier

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

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The Money Multiplier

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00

Total Liabilities$90.00

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The Money Multiplier

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00

Total Liabilities$90.00

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The Money Multiplier

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00

Total Liabilities$90.00

Total Money Supply = $190.00!

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Tools of Monetary ControlThe Fed has three instruments of monetary control:

Open-Market Operations: Buying and selling bonds.

Changing the Reserve Ratio:

Increasing or decreasing the ratio.

Changing the Discount Rate:

The interest rate the Fed charges other banks for loans.

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Problems in Controlling the

Money Supply

Two problems that the Fed must wrestle that arise due to

fractional-reserve banking:

The Fed does not control the amount of money that

households choose to hold as deposits in banks.The Fed does not control the amount of money that bankers

choose to lend.

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