Chapter 9: Money, banks, and the Federal Reserve System

Money

any asset that is generally accepted in exchange for goods and services or payments of debts

examples of money

cash, bank deposits, salt, silk, and barley (commodity money)

barter system

exchange of goods for goods

double coincidence of wants

when two people each have exactly what the other wants and are willing to trade

The four functions of money

1. Medium of exchange

2. Unit of account

3. Store of value

4. Standard for deferred payments

Medium of exchange

money is what you use to buy and sell things

Unit of account

money is how you measure and compare value (prices)

Store of value

money not spent today can be kept for future spending (shares of sock, real estate, etc) AND money is more liquid (advantage)

Standard for deferred payments

money can be used to pay debts in the future.

Qualities of good money

• must be accepted by most people

• Must be standardized quality (units should be identical)

• It should be durable

• Should be valuable relative to its weight (it actually has its own worth)

• Should be divisible (helps to facilitate both small and large transactions)

Fiat money

Money that has value because the government says it does, not because it’s made of something valuable

Legal tender

Money that must be accepted for payment of debts by law

what two broad measures is money supply represented by in the US

M₁ and M₂

M₁

the narrower measure that includes:

• currency (paper money and coins held by households; excludes currency held by banks)

• Checkable deposits (Money in a bank account that you can spend anytime)

• Savings deposits (Money in a bank account meant for saving)

M₂

A broader measure of money that includes all assets in M₁ plus:

• small denomination time deposits that have a value of less than $100,000

  • Money you put in the bank for a set time that earns interest.

• Non institutional money market mutual funds

  • Investment accounts for regular people that are easy to access and count as money

How do banks create money

• commercial banks accept deposits from individuals and businesses

• Banks make loans to individual and firms

• By accepting deposits and making loans, banks create money

Assets vs. Liabilities

• Asset Something a person or company owns that has value.

• Liability: Something a person or company owes to someone else.

Balance Sheet

a financial statement that shows what a person or company owns (assets) and owes (liabilities) at a specific time.

Asset side of balance sheet

• reserves

• Loans

• Financial Securities

• Buildings and equipments

• Other assets

Liability side of balance sheet

• deposits

• Short-term borrowing

• Long-term debt

• Other liabilities

What does assets =

Total liabilities and shareholders

the fractional reserve banking system

• banks are required to hold a fraction of their checking account deposits as reserves

Required reserves

Money from deposits that a bank must keep on hand (in its vault or at the central bank) and cannot lend out

Required reserve ratio

The percentage of deposits that a bank is required to keep in reserve and cannot lend out

excess reserves

any reserves held by a bank over the required reserves

What is the maximum amount of money that can come out of the banks initial deposit

$10,000 (out of an initial deposit of $1000)

The simple money multiplier

tells you how much total money the banking system can create from one initial deposit

the simple money multiplier equation

1/reserve ratio (in decimal form)

change in Checkable deposits equation

Multiplier x initial deposit (initial deposit x 1/rr)

Assumptions in the money creation process

1. No cash is held by the public

• People do not keep cash

• All loan money is redeposited into banks

2. Banks hold no excess reserves

• Banks keep only the required reserves

• They loan out all extra money

fractional reserve banking system

means that banks do not keep 100% of the money deposited with them and instead, most deposits are loaned out

What happens when withdrawals > deposits

• banks use excess reserves to cover short fall

• They can also borrow from other banks

Bank run

when depositors lose confidence in a bank, and all withdrawal their money at once

bank panic

a bank run on many banks

how do bank panics disrupt economic activity

• depositors can’t access their money

• Business are unable to borrow for investment

• Households unable to borrow / purchase new homes, cars, etc

Lenders of last resort

Banks around the would working to prevent bank panics

the Federal Reserve system (the Fed)

the central bank of the United States (Federal Reserve act of 1913)

Discount loans

loans made by the fed to banks

discount rate

interest rate charged on discount loans

what did congress create to prevent bank panics

• FDIC (federal deposit insurance corporation)

• It guarantees that if a bank fails, depositors will get their money back, up to a certain limit (currently $250,000 per account)

how many federal reserve districts are there

12 — each with a federal reserve bank to serve the banks within the district

Who is the main decision-making body of the Federal Reserve system

the federal reserve board of governors in DC — 7 members approved by the senate and president

monetary policy

Policies made by the Fed that manage money supply

What are the 4 main monetary policies

1. Open market operations

2. Discount policy

3. Reserve requirements

4. Interest on reserves

Open Market Operations

• involves the Fed purchasing or selling US treasury securities (T bills)

Open market sale

reduces money supply, increases interest rates

Open market purchase

Increases money supply, decreases interest rates

The federal Open market committee

committee responsible for managing money supply in the US

• they meet 8 times per year

• 12 members

  • 7 members of the Federal board of governors

  • The president of the federal reserve bank of NYC

  • 4 presidents from the other 11 Federal reserve banks

Discount policy

• When banks do not have enough liquidity to handle withdrawals, they can borrow from the Fed

• discount loans and discount rates

  • A high discount rate reduces money supply and rises interest rate banks charge on loans

  • A low discount rate increases money supply and reduces the interest rate

Reserve Requirements

• The required reserve ratio

  • ↑ in the rrr = ↓ money supply and ↑ interest rates

  • A ↓ in the rrr = ↑ money supply and ↓ interest rate

what is the rrr for the United States

0% since 2020

Interest on Reserves

• an ↑ IOR leads to banks keeping more reserves, which ↓ money supply and ↑ interest rates

• A ↓ IOR leads to banks keeping less reserves/loaning more, which ↑ money supply and ↓ interest rates

The quantity theory of money

The amount of money in the economy determines overall price level

• More money → prices go up (inflation)

• Less money → prices go down (deflation)

The quantity equation

shows the relationship between money and prices

• m = money supply

• V = velocity of money

• P = price level

• Y = real gdp

• P x Y = nominal gdp

velocity of money

the number of times a dollar is spent on goods and services included in GDP

velocity of money equation

V = (P x Y)/ M — OR, (nominal gdp)/(money supply)

Inflation equation

%△P = %△M - %△Y

• P = inflation

• M = money growth

• Y = growth in real GDP

Predictions about the inflation rate

• if money supply grows faster than the growth in real gdp, there will be inflation

• If money supply grows slower than real gdp, there will be deflation

• If money supply grows at the same pace as real gdp, the inflation rate will be 0