Monetary System

Three functions of money

Medium of exchange, store of value, unit of account

Fiat money

Money with no intrinsic value (e.g., paper currency)

Commodity money

Money with intrinsic value (e.g., gold coins, cigarettes in POW camps)

Money supply

The quantity of money available in the economy

Monetary policy

Control over the money supply, conducted by the central bank

U.S. central bank

The Federal Reserve ("the Fed")

Open market operations (OMOs)

The Fed's purchase and sale of government bonds; its preferred tool of monetary control

M1

C + demand deposits, travelers' checks, other checkable deposits

M2

M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts

Money supply equation

M=C+D

Reserves (R)

The portion of deposits that banks have not lent out

Bank balance sheet: assets and liabilities

Assets include reserves and loans; liabilities include deposits

100-percent-reserve banking

Banks hold all deposits as reserves; has no impact on the size of the money supply

Fractional-reserve banking

Banks hold a fraction of deposits as reserves and lend out the rest; banks create money

Total money from an initial deposit

(1/rr)*initial deposit

Bank capital

The resources a bank's owners have put into the bank (owners' equity)

Bank capital equation

Capital=assets-liabilities

Leverage

The use of borrowed money to supplement existing funds for purposes of investment

Leverage ratio

Assets/capital

Why is high leverage risky?

A small fall in assets can wipe out capital

Capital requirement

Minimum amount of capital mandated by regulators so banks can pay depositors; higher for riskier assets

Monetary base (B)

B=C+R; controlled by the central bank

Reserve-deposit ratio (rr)

rr=R/D; depends on regulations and bank policies

Currency-deposit ratio (cr)

cr=C/D; depends on households' preferences

Money multiplier (m)

The increase in the money supply resulting from a one-dollar increase in the monetary base

Money multiplier formula

m=(cr+1)/(cr+rr)

Money supply in terms of the monetary base

M=m*B

Change in money supply

ΔM = m × ΔB

If rr < 1, then m is…

Greater than 1

Discount rate

The interest rate the Fed charges on loans to banks

Fed lowers the discount rate

Banks borrow more reserves, so the monetary base rises

How the Fed increases the monetary base with OMOs

Buys government bonds, paying with new dollars

Reserve requirements

Fed regulations that impose a minimum reserve-deposit ratio

Fed reduces reserve requirements

rr falls, so m rises and M rises

Interest on reserves

The Fed pays interest on bank reserves deposited with the Fed

Fed pays a lower interest rate on reserves

rr falls, so m rises and M rises

Excess reserves

Reserves above the reserve requirement

Federal funds rate

The interest rate on loans between banks (banks short on reserves borrow from banks with excess reserves)

How the Fed raises the fed funds rate

Sells government bonds (OMO), which removes reserves, shifts the supply of federal funds left, and raises the rate

Why the Fed can't precisely control M

Households can change cr and banks can change excess reserves (rr); both change m and M

Gross leverage ratio

Assets/stockholder equity

Quantitative easing (QE)

Fed bought long-term government bonds (not T-bills) and mortgage-backed securities to reduce long-term rates and help housing

Risk of QE

If banks lend more as the economy recovers, rapid money growth could cause inflation; the Fed considered "exit strategies"

Policy that helps prevent bank runs

Federal Deposit Insurance