The Monetary System

Double Coincidence of Wants

The occurrence that two people each have a good the other wants

Money

The set of assets that people regularly use to buy g&s from other people

Three Functions of Money

Medium of exchange. Unit of account, Store of value

Medium of Exchange

An item buyers give to sellers when they want to purchase g&s

Unit of account

The yardstick people use to post prices and record debts

Store of value

An item people can use to transfer purchasing power from the present to the future

Commodity money

Takes the form of commodity with an intrinsic value (gold coins, cigarettes in POW camps)

Flat Money

Money without intrinsic value, used as money because of government decree (ex: the US dollar)

Money Supply/ Money Stock

The quantity of money available in the economy

Currency

The paper bills and coins in the hands of the (non-bank) public

Demand deposits

Balances in bank accounts that depositors can access on demand by writing a check

Central Bank

An institution that oversees the banking system and regulates the money supply

Monetary policy

The setting of the money supply by policymakers in the central bank

Federal Reserve (The fed)

The Central Bank of the U.S.

Fractional Reserve Banking System

Banks keep a faction of deposits as reserves and use the rest to make loans

Reserve requirements

Established by the Fed, regulations on the minimum amount of reserves that banks must hold against deposits (Banks can hold more than this minimum amount if they choose)

Reserve Ratio, R

Fraction of deposits that banks hold as reserves, total reserves as a percentage of total deposits

T-account

A simplified accounting statement that shows a bank’s assets and liabilities

Money Multiplier

The amount of money banking system generates with each dollar of reserves

Assets

Reserves, Loans, Securities

Liabilities

Deposits, Debt, and Equity issuances

Bank Capital

The resources a bank obtains by issuing equity to its owners

Leverage

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

Capital Requirement

A government regulation that specifies a minimum amount of capital, intended to ensure banks will be able to pay off depositors and debts

Leverage Ratio

The ratio of assets to bank capital

Money Supply Formula

Money Multiplier x Bank Reserves

Open Market Operations

The purchase and sale of U.S. government bonds by the Fed

• Fed buys gov. bonds from banks, paying by depositing new reserves in that bank’s reserve account

• With more reserves, the bank can make more loans, increasing the money supply

• Fed sells government bonds to decrease bank reserves and the money supply

Discount Rate

The interest rate on loans the Fed makes to banks

Term Auction Facility

the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans

How to induce banks behavior

Traditionally, adjusting the discount rate; New method is using Term Auction Facility

Reducing reserve requirements will…

lower the reserve ration and increase the money multiplier

Raising the interest rate would…

increase the reserve ration and lower the money multiplier

Problem controlling the money supply

If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls

Problems controlling the money supply

If banks hold more reserves than required, they make fewer loans and money supply falls

Run on Banks

When people suspect their banks are in trouble they may “run” to the bank to withdraw their funds

Federal Funds Rate

Interest rate on loans between banks, Fed uses OMOs to target this and changes in it can cause changes in other rates