Money and the Federal Reserve System

Money

• Money: Any asset generally accepted in exchange for goods, services, or debt payment.
  • Acceptability is known as liquidity.
  • Dollar bills are liquid due to universal acceptance despite lacking intrinsic value.
• Liquidity: An asset's acceptability as a medium of exchange.

Functions of Money

• Four primary functions:
  • Medium of exchange
  • Unit of account
  • Store of value
  • Standard of deferred payment

Medium of Exchange

• Facilitates trade by reducing transaction costs.
  • Acts as a "lubricant" in the economy.
  • Reduces the need for barter.
• Barter: Direct exchange of goods/services.
  • Difficult, time-consuming, high transaction costs.
  • Requires a double coincidence of wants: each party must have what the other desires.
  • Money avoids bartering's limitations.

Unit of Account

• Enables measurement and comparison of different goods/services values.
  • Acts as a "yardstick" for value.
  • Simplifies profit calculation by expressing revenue/costs in monetary terms.
• Reduces the number of relative prices to keep track of.
  • Without money, each good's value must be measured against all others.
• Formula for relative prices:
  • $relative prices = [N(N – 1)] / 2$
  • N = number of goods in the economy.

Store of Value

• Money's durability allows wealth accumulation.
  • Easier to store compared to perishable goods or non-storable services.

Standard of Deferred Payment

• Allows debts to be expressed/repaid with equivalent items.
  • Money is fungible: substitutable/replaceable.
  • Facilitates borrowing/lending.
  • Reduces transaction costs as the exact same currency is not required for repayment.

Money as a Cultural Phenomenon

• Value and acceptability are culturally defined.
  • Faith in the stability of a governing body gives currency value.
  • Significant amount of U.S. currency is held outside the U.S.

Measuring Money

• Measured based on liquidity.
  • The Fed uses M1, M2, and M3 monetary aggregates.
  • Liquidity decreases from M1 to M3.

M1

• Most liquid measure.
  • M1 = currency and coins + checking account deposits (demand deposits) + travelers’ checks + other liquid deposits (including savings deposits).
  • Includes share draft accounts at credit unions and NOW accounts at commercial banks.

M2

• Broader than M1.
  • M2 = M1 + small denomination time deposits (< $100,000) (CDs) + non-transactions deposits + money market deposit accounts + non-institutional money market mutual fund shares.
  • Includes personal non-transaction accounts.

M3

• Broadest measure.
  • M3 = M2 + large denomination time deposits (>$100,000) + institutional money market mutual funds + repurchase agreements + term Eurodollars.
  • Institutional refers to large investors (corporations, governments, pension plans).
  • Repurchase agreement (repo): Loan using a security as collateral.
  • Eurodollars: U.S. dollars held in foreign banks.
• The Federal Reserve discontinued the publication of M3 statistics in March of 2006 because it felt that the costs of measuring the statistics were not worth the additional information provided by the series.

Summary

• M1 = cash and liquid accounts
• M2 = M1 + non-liquid personal accounts
• M3 = M2 + institutional savings.

A Brief History of Money

• Evolution: BARTER → COMMODITY MONEY → COINS → FIAT MONEY → CHECKS → ELECTRONIC MONEY

Commodity Money

• Asset with intrinsic value apart from its use as money.

• Examples:

  • Babylon, Assyria – barley
  • India – almonds
  • Greece – iron nails
  • Aztecs – cocoa beans
  • Nicobar Islands – coconuts
  • Yap Islands – large stone wheels
  • Mongolia – bricks of tea
  • Asia – rice, cowrie shells
  • Norway – butter, dried cod

• Characteristics for effective commodity money:

  • Limited supply
  • Durable
  • Divisible
  • Have value apart from its use as money, especially if high demand by wealthy
  • Portable
  • Fungible

• Precious metals (gold, silver) became dominant due to these qualities.

Coins

• Eliminated the need to weigh and assay precious metals.
  • Governments attest to weight and purity.
  • Reduced transaction costs.
  • First coins minted in Lydia (600 B.C.) - staters (electrum).
  • Spread throughout Greece and Rome.

Fiat Money

• Acceptable because the government mandates it.
  • Also known as fiduciary money.
  • Initially represented commodity value (tobacco, silver).
  • Modern fiat money has no intrinsic value.
  • "This note is legal tender for all debts, public and private".

Checks

• Provided protection against theft, especially over distances.
  • Grew in use after the Civil War in the United States.

Electronic Money

• ATFs, debit cards, stored value cards, Paypal, ApplePay, electronic checks.
  • Frees exchange from time and place restrictions.
  • Funds transfer instantaneously.
  • Reduces transaction costs.
  • JPay (used in the U.S. penal system) is an example.
  • May lead to decreased population density.

Cryptocurrency

• Digital currency without government backing.
  • Created via encryption algorithms.
  • Transactions recorded and verified through blockchain.
  • Examples: Bitcoin, Litecoin, Ethereum.
  • Wallets are software-based (cloud or personal computer).
• Benefits:
  • Not accessible to public agencies (government).
  • Anonymity.
• Disadvantages:
  • Risk/volatility.
  • Wallet access is crucial.
• Does not fully function as money:
  • Limited transaction use.
  • Difficult conversion to traditional currencies.
  • Inconsistent as a unit of account or store of value.

Money and Banking Timeline (640 B.C. – 1781 A.D.)

• 640 B.C.: Lydia introduces first coins (staters).
• 630 B.C.: Greek city-states begin minting coins.
• 600 B.C.: Athenian tetradrachma introduced. First Chinese coins during Chou dynasty.
• 500s B.C.: Commerce thrives in Greek city-states.
• 490 B.C.: Corinthian “ponies” are the first with denominations.
• 350s B.C.: Macedonia conquers Greek city-states; Alexander the Great standardizes money.
• 323 B.C.: Alexander the Great's image on a coin.
• 320s B.C.: Rome mints silver coins and expands.
• 200s B.C.: Rome issues silver Denarius.
• 100s B.C.: Rome accumulates gold reserve.
• 68 B.C.: First Jewish Shekel created.
• 50s B.C.: Julius Caesar mints gold Aureus.
• 31 B.C.: Augustus' rule; Aureus spreads widely; Denarius created; authority to mint transfers from Senate to Augustus.
• 20s A.D.: Coin shortage in Roman Empire; commodity money (salt) re-emerges.
• 64 A.D.: Rome burns; Nero reduces silver content of coins, leading to inflation.
• 200 A.D.: Loss of faith in Roman monetary system; return to barter.
• 618 A.D.: Chinese first use of paper money.
• 1000s A.D.: Europe in Dark Ages due to lack of money/commerce.
• 1200s A.D.: European countries begin to mint coins.
• 1400s A.D.: Fiat money develops in the West (Venice); banking system arises (Medici); Amsterdam goldsmiths and fractional reserve banking.
• 1558 A.D.: Elizabeth I becomes Queen; Gresham's Law: "bad money drives out good money."
  • If two coins are circulating at the same time, one of high quality and one of low quality, then people will spend the low quality coins and hoard the high quality coins.
• 1700s: Europe strengthens coinage; American colonies use various forms of money.
• 1775-1781: Continental Congress issues continentals, leading to hyperinflation.

The Impact of Money

• Without money:
  • Trade is difficult.
  • Self-sufficiency is required.
  • Little leisure time.
  • Taxes raised in-kind.
  • Difficult wealth transfer.
• With money:
  • Facilitates trade and fosters commerce.
  • Allows markets to develop.
  • Merchant class arises.
  • Leisure time possible.
  • Arts and culture prosper.

The Federal Reserve System

• Structure mimics the U.S. national government.
  • Separation of powers and federalism.
  • 12 regional banks to avoid power concentration.
• President selects the Board of Governors (14-year staggered terms).
• Member commercial banks purchase stock in regional Federal Reserve Banks.
• The Federal Open Market Committee (FOMC) guides monetary policy.
• Creation was a political process with debates and compromises.
  • Panics of 1893 and 1907 highlighted the need for a central bank.
  • Nelson Aldrich recommended a central bank controlled by bankers.
  • Progressives (William Jennings Bryan) opposed banker control.
  • The Federal Reserve Act of 1913 was the compromise.

Central Banks Around the World

• The United States was fairly late to adopt a central bank compared to most other countries.
• Most countries have more centralized banks than the U.S. Federal Reserve System.
• Goals: control money supply, maintain financial and price stability, provide an efficient payments system.
• Trend toward greater central bank independence for financial stability.

The Federal Reserve System: Purposes and Functions

• Established in 1913 to provide a pool of reserve funds for member banks.
• Originally meant to increase banking system liquidity.
• Original legislative purpose: “a safer, more flexible, and more stable monetary and financial system.”
• Four functional areas:
  • Conducting monetary policy
  • Bank supervision and regulation
  • Maintaining financial stability
  • Providing financial services to the U.S. government, financial institutions, and the public, and operating the nation’s payments system.

The Federal Reserve System: Structure

• Insulated from political pressures via staggered terms.
• Balances interests of bankers and the public.
• Institutions:
  • The Board of Governors of the Federal Reserve System
  • The Federal Open Market Committee
  • The Federal Advisory Council
  • The Consumer Financial Protection Bureau
  • 12 regional Federal Reserve Banks
  • About 1500 member commercial banks.

The Board of Governors

• Sets the general direction of monetary policy and oversees the other parts of the system.
• Seven members with staggered, 14-year terms.
• Responsibilities:
  • Analyzing current domestic and international economic and financial developments.
  • Supervising and regulating Federal Reserve Banks.
  • Maintaining the nation’s payments system.
  • Protecting consumers.
  • Conducting monetary policy.
• Controls the system in many ways:
  • Makes up seven of twelve members of the Federal Open Market Committee (FOMC).
  • Chooses three of each of the Federal Reserve Bank’s Directors, known as Type C Directors who are meant to protect the public interest.
  • Has responsibility over monetary policy; directly sets reserve requirements; it reviews and determines the discount rate after it has been established by the Federal Reserve Banks.

The Federal Open Market Committee

• Consists of the seven members of the Board of Governors, the New York Fed President, and four other Federal Reserve Bank presidents who rotate among themselves.
• The New York Fed implements open market operations.
• Meets eight times per year to assess the economy and set a direction for monetary policy.
• Sets a target for the Federal Funds Rate for the next six weeks and instructs the New York Fed to conduct open market operations.
• Each morning, the New York Fed predicts changes in the demand for bank reserves for the day and then uses open market operations to keep the Federal Funds Rate on target.

Federal Advisory Council

• Consists of twelve representatives, one from each of the Federal Reserve Bank presidents.
• Meets advises the Board of Governors and FOMC.

Twelve Federal Reserve Banks

• A decentralized system of twelve regional banks.
• Avoids concentration of political and economic power among bankers and financiers in New York City known as the “Money Trusts”.
• Distribution was a subject of intense competition between cities in 1914.
• Along with the twelve district banks, there are also 24 Federal Reserve Branches.

Directors

• Type A Directors: are elected by member banks to represent professional bankers.
• Type B Directors: are elected by member banks to represent industry and commercial interests.
• Type C Directors: are appointed by the Board of Governors to represent the public interest. They are not involved in banking.
• The Board of Directors consists of three Type A Directors, three Type B Directors, and three Type C directors for each of the Twelve Federal Reserve Banks.

Functions

• Clearing checks.
• Issuing new currency
• Withdrawing damaged currency
• Administering discount loans
• Evaluating mergers and expansions
• Acting as a liaison between businesses and the Board of Governors.
• Examining bank holding companies and state member banks.
• Collecting data on local business conditions.
• Conducting economic research for monetary policy.
• Assisting with the implementation of monetary policy.
• Federal Reserve Banks assist with monetary policy in several ways. They establish the discount rate in each region, in consultation with the Board of Governors. They decide which banks in their region can obtain discount loans. They select one commercial banker to serve on the Federal Advisory Council.

Member Commercial Banks

• Decline in numbers due to mergers and re-chartering.
• Nationally chartered banks must be members.
• Costs of joining the Fed can be high.
  • Banks are required to hold 3% of their bank capital as stock in their district Federal Reserve Bank. These equity investments are limited by law to a return of 6%.
  • The bank is required to hold a certain percentage of its reserves in its district bank’s Federal Reserve Account, which pays no or little interest.
  • The opportunity cost of funds devoted to membership in the Federal Reserve System may be excessive.
• IDMCA (Depository Institutions Deregulation and Monetary Control Act) of 1980 required that all banks hold reserve requirements, so part of the costs to membership was eliminated.
• Member banks are important for the money creation process.
  • Banks create money through loans and deposits.