Macro - The Monetary System

What would trade require without money?

Trade would require barter and a double coincidence of wants

What is barter?

the exchange of one good or service for another

What is a double coincidence of wants?

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

What is money?

the set of assets that people regularly use to buy goods and services from other people

What are the 3 functions of money?

1. Medium of exchange

2. Unit of account

3. Store of value

What is a medium of exchange?

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

What is a unit of account?

the yardstick people use to post prices and record debts

What is a store of value?

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

What is wealth?

the total of all stores of value

What is liquidity?

how fast an asset can be turned into the medium of exchange

What are the 2 kinds of money?

1. Commodity money

2. Fiat money

What is commodity money?

takes the form of a commodity with intrinsic value

What are some examples of commodity money?

Ex: gold coins, Ramen noodles in prisons

What is fiat money?

money without intrinsic value, used as money because of government decree

What is an example of fiat money?

the U.S. dollar

What is the money supply (or money stock)?

the quantity of money available in the economy

What are the two candidates for assets that should be considered of the money supply?

1. currency

2. demand deposits

What is currency?

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

What are demand deposits?

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

What is M1?

currency, demand deposits, savings deposits, and other checkable deposits

What is M2?

everything in M1 plus small time deposits, retail money market mutual funds, and a few minor categories

What is the central bank?

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

What is monetary policy?

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

What is the Federal Reserve (Fed)?

the central bank of the U.S.

What does the Federal Reserve System consist of?

• Board of Governors (7 members), located in Washington, DC

• 12 regional Fed banks, located around the U.S.

• Federal Open Market Committee (FOMC), includes the 7 BoGs and presidents of 5 of the regional Fed banks, the FOMC decides monetary policy

What happens in a fractional reserve banking system?

banks keep a fraction of deposits as reserves and use the rest to make loans

What are reserve requirements?

regulations on the minimum quantity of reserves that banks must hold against deposits

What is the reserve ratio (R)?

= fraction of deposits that banks hold as reserves

= total reserves as a percentage of total deposits

What is a T-account?

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

Money supply formula

Money supply = currency + deposits

Money supply = money multiplier x bank reserves

What happens in a 100% reserve banking system?

banks do not affect size of money supply

What does a fractional reserve banking system create

creates money, but not wealth

What is a money multiplier?

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

Formula for money multiplier

money multiplier = 1/R

How can the Fed change the money supply?

By changing bank reserves or changing the money multiplier

What are Open-Market Operations (OMOs)?

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

What happens when the Fed buys a government bond from a bank?

It pays by depositing new reserves into that bank’s reserve account

What happens when banks get more reserves?

the bank can make more loans, increasing the money supply

How can bank reserves and the money supply decrease?

the Fed sells government bonds

What is the traditional method of how the Fed influences reserves?

adjusting the discount rate - the interest rate on loans the Fed makes to banks - to influence the quantity of reserves banks borrow

What is the new method of how the Fed influences reserves?

Standing Repo Facility - eligible depository institutions can swap reserves form the Fed for collateral (ex: US Treasuries) and agree to buy bank the collateral the next day

What is the ratio for banks borrowing to reserves?

the more banks borrow, the more reserves they have for new loans, increasing the money supply

Reserve ratio formula

reserve ratio = reserves / deposits

What does the reserve ratio do to the money multiplier?

It inversely affects the money multiplier

What are reserve requirements?

regulations on the minimum quantity of reserves banks must hold against deposits

What would happen is reserve requirements were reduced?

reducing reserve requirements would lower the reserve ratio and increase the money multiplier

What would happen to the reserve ratio and money multiplier in interest rates increased?

Raising interest rates on reserves banks would increase the reserve ratio and lower the money multiplier

What happens to banks if households hold more of their money as currency?

Banks have fewer reserves, make fewer loans, and money supply falls

What happens if banks hold more reserves than required?

Banks make fewer loans and money supply falls

Who can compensate for household and bank behavior to retain some control over the money supply?

The Fed