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

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

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

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

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