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Chapter 16 - The Monetary System

16.1: The Meaning of Money

  • Money- the set of assets in an economy that people regularly use to buy goods and services from other people

The Function of Money:

  • Medium of exchange- an item that buyers give to sellers when they want to purchase goods and services

  • Unit of discount- the yardstick people use to post prices and record debts

  • Store of value- an item that people can use to transfer purchasing power from the present to the future

  • Liquidity- the ease with which an asset can be converted into the economy’s medium of exchange

The Kinds of Money:

  • Commodity money- money that takes the form of a commodity with intrinsic value

  • Flat money- money without intrinsic value that is used as money because of government decree

Money in the U.S. Economy:

  • Currency- the paper bills and coins in the hands of the public

  • Demand deposits- balances in bank accounts that depositors can access on demand by writing a check

16.2: The Federal Reserve System:

  • Federal Reserve (Fed)- the central bank of the United States

  • Central bank- an institution designed to oversee the banking system and regulate the quantity of money in the economy

The Fed’s Organization:

  • Run by its board of governors (7 members) appointed by the president and confirmed by the senate

    • Chairman is the most important position

  • Fed’s jobs are to regulate banks and ensure the health of the banking system and control the money supply

    • Money supply- the quantity of money available in the economy

  • Monetary policy- the setting of the money supply by policymakers in the central bank

The Federal Open Market Committee:

  • Open-market operation- the purchase and sale of U.S. government bonds

    • U.S. government bond is a certificate of indebtedness of the federal government

16.3: Banks and the Money Supply

The Simple Case of 100-percent-Reserve Banking:

  • Reserves- deposits that banks have received but have not loaned out

Money Creation with Fractional-Reserve Banking:

  • Fractional-reserve banking- a banking system in which banks hold only a fraction of deposits as reserves

  • Reserve ratio- the fraction of deposits that banks hold as reserves

The Money Multiplier:

  • Money multiplier- the amount of money the banking system generates with each dollar of reserves

Bank Capital, Leverage, and the Financial Crisis of 2008–2009:

  • Bank capital- the resources a bank’s owners have put into the institution

  • Leverage- the use of borrowed money to supplement existing funds for purposes of investment

  • Leverage ratio- the ratio of assets to bank capital

  • Capital Requirement- the government regulation specifying a minimum amount of bank capital

16.4: The Fed’s Tools of Monetary Control

How the Fed Influences the Quantity of Reserves:

  • Open-market operations- the purchase and sale of U.S. government bonds by the Fed

  • Fed Lending to Banks

    • Discount rate- The interest rate on the loans that the Fed makes to banks

How the Fed Influences the Reserve Ratio:

  • Monetary policy tools

    • Reserve requirements- regulations on the minimum amount of reserves that banks must hold against deposits

    • Paying Interest on Reserves

Problems in Controlling the Money Supply:

  1. The Fed does not control the amount of money that households choose to hold as deposits in banks

    1. The balance of reserves in banks rely on the amount of money households choose to deposit

  2. Feds do not control the amount that bankers choose to lend

    1. Because of the bankers’ decision to take loans, the money supply falls

  3. The amount of money in the economy depends in part on the behavior of depositors and bankers

The Federal Funds Rate:

  • Federal funds rate- the interest rate at which banks make overnight loans to one another

16.1: The Meaning of Money

  • Money- the set of assets in an economy that people regularly use to buy goods and services from other people

The Function of Money:

  • Medium of exchange- an item that buyers give to sellers when they want to purchase goods and services

  • Unit of discount- the yardstick people use to post prices and record debts

  • Store of value- an item that people can use to transfer purchasing power from the present to the future

  • Liquidity- the ease with which an asset can be converted into the economy’s medium of exchange

The Kinds of Money:

  • Commodity money- money that takes the form of a commodity with intrinsic value

  • Flat money- money without intrinsic value that is used as money because of government decree

Money in the U.S. Economy:

  • Currency- the paper bills and coins in the hands of the public

  • Demand deposits- balances in bank accounts that depositors can access on demand by writing a check

16.2: The Federal Reserve System:

  • Federal Reserve (Fed)- the central bank of the United States

  • Central bank- an institution designed to oversee the banking system and regulate the quantity of money in the economy

The Fed’s Organization:

  • Run by its board of governors (7 members) appointed by the president and confirmed by the senate

    • Chairman is the most important position

  • Fed’s jobs are to regulate banks and ensure the health of the banking system and control the money supply

    • Money supply- the quantity of money available in the economy

  • Monetary policy- the setting of the money supply by policymakers in the central bank

The Federal Open Market Committee:

  • Open-market operation- the purchase and sale of U.S. government bonds

    • U.S. government bond is a certificate of indebtedness of the federal government

16.3: Banks and the Money Supply

The Simple Case of 100-percent-Reserve Banking:

  • Reserves- deposits that banks have received but have not loaned out

Money Creation with Fractional-Reserve Banking:

  • Fractional-reserve banking- a banking system in which banks hold only a fraction of deposits as reserves

  • Reserve ratio- the fraction of deposits that banks hold as reserves

The Money Multiplier:

  • Money multiplier- the amount of money the banking system generates with each dollar of reserves

Bank Capital, Leverage, and the Financial Crisis of 2008–2009:

  • Bank capital- the resources a bank’s owners have put into the institution

  • Leverage- the use of borrowed money to supplement existing funds for purposes of investment

  • Leverage ratio- the ratio of assets to bank capital

  • Capital Requirement- the government regulation specifying a minimum amount of bank capital

16.4: The Fed’s Tools of Monetary Control

How the Fed Influences the Quantity of Reserves:

  • Open-market operations- the purchase and sale of U.S. government bonds by the Fed

  • Fed Lending to Banks

    • Discount rate- The interest rate on the loans that the Fed makes to banks

How the Fed Influences the Reserve Ratio:

  • Monetary policy tools

    • Reserve requirements- regulations on the minimum amount of reserves that banks must hold against deposits

    • Paying Interest on Reserves

Problems in Controlling the Money Supply:

  1. The Fed does not control the amount of money that households choose to hold as deposits in banks

    1. The balance of reserves in banks rely on the amount of money households choose to deposit

  2. Feds do not control the amount that bankers choose to lend

    1. Because of the bankers’ decision to take loans, the money supply falls

  3. The amount of money in the economy depends in part on the behavior of depositors and bankers

The Federal Funds Rate:

  • Federal funds rate- the interest rate at which banks make overnight loans to one another