Money-Chapter 04

ECON100B Macroeconomics Week 07: The Monetary System

Introduction

  • Instructor: Mina Mirazimi

  • Topic: The Monetary System: What It Is and How It Works

Chapter Overview

The Monetary System: What It Is and How It Works

  • Key Topics:

    • Definition, functions, and types of money

    • How banks "create" money

    • Role of a central bank in controlling the money supply

  • Definition of Money:

    • Stock of assets readily used to make transactions.

Functions and Types of Money

Functions of Money

  • Medium of Exchange:

    • Used to buy goods and services.

  • Store of Value:

    • Transfers purchasing power from present to future.

  • Unit of Account:

    • Common unit for measuring prices and values.

Types of Money

  1. Fiat Money:

    • No intrinsic value (e.g., paper currency).

  2. Commodity Money:

    • Has intrinsic value (e.g., gold coins, cigarettes in POW camps).

Discussion Question

  • Which of the following are money?

    • a. Currency

    • b. Checks

    • c. Demand deposits

    • d. Credit cards

    • e. Certificates of deposit

The Central Bank and Monetary Control

  • Money Supply:

    • Quantity of money available in an economy.

  • Monetary Policy:

    • Control over the money supply performed by central bank.

  • U.S. Central Bank:

    • Known as the Federal Reserve ("the Fed").

  • Methods of Control:

    • Open-market operations, purchasing and selling government bonds.

Roles and Goals of the Central Bank

Roles and Powers

  • Monopoly supplier of currency.

  • Banker to the government.

  • Lender of last resort.

  • Conductor of monetary policy.

  • Supervisor of the banking system.

  • Regulator of payment system.

General Objectives

  • Ensure low and stable inflation.

  • Maximize employment and economic growth.

  • Maintain financial stability.

  • Ensure payment security and efficiency.

  • In some cases, target exchange rates.

The Federal Reserve System

  • Oversight:

    • Congress oversees the Federal Reserve System.

  • Structure:

    • Federal Open Market Committee (FOMC): consisting of Board members, Reserve Bank presidents.

    • The Federal Reserve operates as an independent agency of the federal government.

Federal Reserve Districts

  • Twelve Federal Reserve Districts:

    1. Boston

    2. New York

    3. Philadelphia

    4. Cleveland

    5. Richmond

    6. Atlanta

    7. Chicago

    8. St. Louis

    9. Minneapolis

    10. Kansas City

    11. Dallas

    12. San Francisco

Money Supply Measures (Dec 2023)

Measurement Symbols and Components

  • C: Currency outside Treasury, Fed, and banks - $2,335.4 billion

  • M1: Currency plus demand deposits, traveler’s checks - $18,139.1 billion

  • M2: M1 plus retail money market fund balances, saving deposits, small time deposits - $20,929.0 billion.

Banks' Role in the Monetary System

  • Equation: M = C + D (Money Supply)

  • Reserves (R): Portion of deposits held by banks.

  • Bank Liabilities: Include deposits; assets include reserves and loans.

Banking Systems

  • 100-percent-reserve banking: Banks hold all deposits as reserves.

  • Fractional-reserve banking: Banks hold a fraction of deposits as reserves.

Money Creation in the Banking System

Scenarios Explored:

  1. No Banks:

    • If no banks exist, M = C = $1,000.

  2. 100-percent-reserve Banking:

    • Initial deposit C = $0, D = $1,000, M = $1,000.

  3. Fractional-reserve Banking:

    • Banks lend out a portion of deposits.

Example Calculations

  • FirstBank Balance Sheet Example:

    • Reserves: $1,000, Loans: $800, M = $1,800 if they lend out.

Finding the Total Amount of Money

Calculation of Total Money Supply

  • Formula: Total money supply = (1/rr) × initial deposit

  • Example with rr = 0.2 leads to total M = $5,000.

  • Notes: Fractional-reserve banking can create money but does not create wealth.

Bank Capital and Leverage

Definitions and Concepts

  • Bank Capital: Resources put into a bank by its owners.

  • Leverage: Using borrowed money for investment.

Risks of High Leverage

  • Vulnerability to asset declines during recessions; example show potential capital loss.

  • Capital Requirement: Minimum capital needed by regulators to ensure banks can meet their obligations.

    • Crisis examples highlight capital shortages leading to government intervention.

Model of the Money Supply

Components and Relationships

  • Monetary Base (B): B = C + R, controlled by central bank.

  • Reserve-deposit Ratio (rr): Relationship affected by bank policies and regulations.

  • Understanding flow: Money supply determined through multiple factors.

Money Multiplier

  • Formula: M = m × B, with adjustments based on currency and reserve ratios.

  • Changes in monetary base affects money supply.

Additional Fed Policy Instruments

Various Instruments

  • Open Market Operations:

    • Buying/selling government bonds adjusts money supply.

  • Discount Rate Adjustments:

    • Lowering the rate encourages bank borrowing, increasing reserves.

Temporary Liquidity Methods

  • Repurchase Agreements (repos): Adding temporary liquidity to banks.

  • Reverse Repos: Removing excess reserves from the system.

Limitations on Fed's Control of Money Supply

  • Changes in household money preferences affect money supply.

  • Banks holding excess reserves complicate control of monetary dynamics.

Case Study: Quantitative Easing

Overview

  • Analysis shows divergence between base growth and actual money supply growth.

  • Fed intervention strategies during crises noted, along with implications for inflation.