Chapter 29: The Monetary System

Chapter 29: The Monetary System

• Barter: the exchange of one good or service for another to obtain the things they need

• Double coincidence of wants: the unlikely occurrence that two people each have a good or service that the other wants

• The existence of money makes trade easier

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Chapter 29.1: The Meaning of Money

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

• Money is related to wealth

• 29.1a: The Functions of Money

  • Money serves as a 
  • Medium of exchange: an item that buyers give to sellers when they want to purchase goods and services
  • Unit of account: 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
  • Since money is the designated medium of exchange, it is the most liquid
  • When allocating wealth, the liquidity of each asset has to be balanced

• 29.1b: The Kinds of Money

  • Commodity money: money that takes the form of a commodity with intrinsic value
  • Intrinsic value means an item would have value even if it were not used as money
  • Ex: Gold, because it is used in the industry. When an economy uses gold as money, it operates under a gold standard
  • Fiat money: money without intrinsic value that is used as money by government decree
  • Ex: The US dollar

• 29.1c: Money in the US Economy

  • Money stock: the quantity of money circulating in the 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

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Chapter 29.2: 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

• 29.2a: The Fed’s Organization

  • Lender of last resort: a lender to those who cannot borrow anywhere else. This is in reference to the Fed
  • Money supply: the quantity of money available in the economy
  • Monetary policy: the setting of the money supply by policymakers in the central bank

• 29.2b: The Federal Open Market Committee

  • The Federal Open Market Committee makes decisions. Through this, the Fed has the power to increase or decrease the number of dollars in the economy
  • Open-market operation: the purchase and sale of US government bonds. This is the Fed’s primary tool to change the money apply
  • Prices rise when the government prints too much money. The Fed determines the inflation in the long run

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Chapter 29.3: Banks and the Money Supply

• 29.3a: THe Simple Case of 100-Percent-Reserve Banking

  • Reserves: deposits that banks have received but have not loaned out
  • A 100-percent-reserve-banking is an imaginary economy where all deposits are held as reserves
  • A balance sheet is an accounting statement where the assets and liabilities are equivalent
  • If banks hold all deposits in reserve, banks do not influence the supply of money

• 29.3b: 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 Fed sets a minimum amount of reserves that banks must hold. This is called a reserve requirement
  • Banks can hold above the reserve requirement, called a excess reserves
  • When banks hold only a fraction of deposits in reserve, the banking system creates money

• 29.3c: The Money Multiplier

  • Money multiplier: the amount of money the banking system generates with each dollar of reserves
  • The money multiplier is the reciprocal of the reserve ratio
  • The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier

• 29.3d: 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
  • A bank is insolvent when it is unable to pay of its debt in full, since its assets fell below its liabilities
  • Capital requirement: a government regulation specifying a minimum amount of bank capital
  • A credit crunch is a shortage of capital which induces banks to reduce lending

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• 29.4: The Fed’s Tools of Monetary Control

  • 29.4a: How the Fed Influences the Quantity of Reserves
  • Open-Market Operations
    • Open-Market Operations: the purchase and sale of US government bonds by the Fed. 
    • To reduce the money supply, the Fed sells government bonds to the public. The public affords this with currency and bank deposits, which reduces the money in circulation
  • Fed Lending to Banks:
    • Typically, banks borrow from the Fed’s discount window and pay an interest on that loan
    • Discount rate: the interest rate on the loans that the Fed makes to banks
    • Term Action Facility: the quantity of funds the Feds wanted to lend to banks, where banks bid on those funds. ran from 2007-2010
    • The Fed lends to banks to help financial institutions 
  • 29.4b: How the Fed Influences the Reserve Ratio
  • Reserve Requirements
    • Reserve requirements: regulations on the minimum amount of reserves that banks must hold against deposits
    • An increase of reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply
    • When the Fed changes their requirements, it affects banks.
  • Paying Interest on Reserves
    • When a bank holds reserves at the Fed, the Fed now pays the bank interest on those deposits
  • 29.4c: Problems in Controlling the Money Supply
  • The Fed’s control of the money supply is not precise, so problems can still arise
  • The Fed does not control the amount of money that households choose to hold as deposits in banks
  • The Fed does not control the amount that bankers choose to lend, therefore the Fed cannot be sure of how much money the banking system will create
  • 29.4d: The Federal Funds Rate
  • Federal funds rate: the interest rate at which banks make overnight loans to one another
  • The discount rate is an interest rate paid to borrow directly from the Fed. The federal funds rate consists of borrowing reserves from another bank rather than from the Fed
  • Interest rates of different loans are strongly correlated with one another, so the federal funds rate has an impact on the economy
  • Open-market purchases lower the federal funds rate. Open-market sales raise the federal funds rate

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