Chapter 10: The Money Supply and the Federal Reserve System

AN OVERVIEW OF MONEY

Definition of Money: Anything that is generally accepted as a medium of exchange.
A Means of Payment, or Medium of Exchange: * Barter: The direct exchange of goods and services for other goods and services. * Medium of exchange, or means of payment: What sellers generally accept and buyers generally use to pay for goods and services.
A Store of Value: * Store of value: An asset that can be used to transport purchasing power from one time period to another. * Liquidity property of money: The property of money that makes it a good medium of exchange as well as a store of value. It is portable and readily accepted and thus easily exchanged for goods.
A Unit of Account: * Unit of account: A standard unit that provides a consistent way of quoting prices.

COMMODITY AND FIAT MONIES

Commodity monies: Items used as money that also have intrinsic value in some other use.
Fiat, or token, money: Items designated as money that are intrinsically worthless.
Legal tender: Money that a government has required to be accepted in settlement of debts.
Currency debasement: The decrease in the value of money that occurs when its supply is increased rapidly.

MEASURING THE SUPPLY OF MONEY IN THE UNITED STATES

M1: Transactions Money: Money that can be directly used for transactions. * $\text{M1} \equiv \text{currency held outside banks} + \text{demand deposits} + \text{traveler’s checks} + \text{other checkable deposits}$
M2: Broad Money: M1 plus savings accounts, money market accounts, and other near monies. * Near monies: Close substitutes for transactions money, such as savings accounts and money market accounts. * $\text{M2} \equiv \text{M1} + \text{savings accounts} + \text{money market accounts} + \text{other near monies}$
The Difficulty of Definition: Beyond M2, there are no hard rules for deciding what is money and what is not. This posing problems for economists and policy-makers.

THE PRIVATE BANKING SYSTEM

Financial intermediaries: Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money (Financial intermediation).
A Historical Perspective: Goldsmiths: * Run on a bank: Occurs when many of those who have claims on a bank (deposits) present them at the same time.
A Brief Review of Accounting: * $\text{Assets} - \text{Liabilities} \equiv \text{Net Worth}$ * $\text{Assets} \equiv \text{Liabilities} + \text{Net Worth}$
The T-Account for a Typical Bank: * Assets: Reserves and Loans. * Liabilities: Deposits and Net Worth.

HOW BANKS CREATE MONEY

Reserves: The deposits that a bank has at the Federal Reserve bank plus its cash on hand.
Required reserve ratio: The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.
Reserve Definitions: * Actual reserves: The total reserves held by the bank. * Excess reserves: The difference between a bank’s actual reserves and its required reserves. * $\text{excess reserves} \equiv \text{actual reserves} - \text{required reserves}$
The Creation of Money Process: Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction. When a bank makes a loan, it creates a deposit for the borrower, thereby increasing the money supply.
The Money Multiplier: The multiple by which deposits can increase for every dollar increase in reserves. An increase in bank reserves leads to a greater than one-for-one increase in the money supply. * $\text{money multiplier} \equiv \frac{1}{\text{required reserve ratio}}$

STEP-BY-STEP DEPOSIT EXPANSION TABLE

This table illustrates how money is created through the banking system given a $10\%$ reserve requirement and an initial deposit of $1,000$ :

Step	Deposit	Reserve Requirement (10%)	Excess Reserves	Loans Made	New Deposits
1	$1,000$	$100$	$900$	$900$	$900$
2	$900$	$90$	$810$	$810$	$810$
3	$810$	$81$	$729$	$729$	$729$
4	$729$	$72.90$	$656.10$	$656.10$	$656.10$
5	$656.10$	$65.61$	$590.49$	$590.49$	$590.49$
6	$590.49$	$59.05$	$531.44$	$531.44$	$531.44$
7	$531.44$	$53.14$	$478.30$	$478.30$	$478.30$
8	$478.30$	$47.83$	$430.47$	$430.47$	$430.47$
9	$430.47$	$43.05$	$387.42$	$387.42$	$387.42$
10	$387.42$	$38.74$	$348.68$	$348.68$	$348.68$

THE FEDERAL RESERVE SYSTEM

Federal Reserve Bank (the Fed): The central bank of the United States.
Structure of the Fed: * Board of Governors: Seven members appointed by the President. * Federal Reserve District Banks: 12 regional banks. * Federal Open Market Committee (FOMC): Composed of the seven Board members, the president of the New York Federal Reserve Bank, and four other district bank presidents (rotating); it sets goals for money supply and interest rates. * Open Market Desk: The office in the New York Federal Reserve Bank that executes the buying and selling of government securities.
Functions of the Federal Reserve: * Clearing Interbank Payments: Managing the movement of funds between computer accounts for banks. * Lender of last resort: Providing funds to troubled banks that cannot find other sources of funds.
The Federal Reserve Balance Sheet (August 3, 2005): * Assets (Total: $820,910 Million): * Gold: $4,037$ million * Loans to banks: $3,330$ million * U.S. Treasury securities: $724,700$ million * All other assets: $88,843$ million * Liabilities (Total: $820,910 Million): * Federal Reserve notes (outstanding): $729,601$ million * Deposits (Bank reserves): $26,130$ million * U.S. Treasury deposits: $4,813$ million * All other liabilities and net worth: $60,366$ million

HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY

The Fed controls the supply of money by manipulating bank reserves. Three primary tools are used:

1. The Required Reserve Ratio

Mechanism: Decreasing the ratio allows banks to make more loans (increasing the money supply); increasing the ratio forces banks to call in loans (decreasing the money supply).
Example (Table 10.2): * Required reserve ratio = $20\%$ : Reserves of $100$ billion support $500$ billion in deposits (M1 = $600$ billion). * Required reserve ratio = $12.5\%$ : Reserves of $100$ billion support $800$ billion in deposits (M1 = $900$ billion).

2. The Discount Rate

Definition: The interest rate banks pay to the Fed to borrow from it.
Mechanism: A higher discount rate increases the cost of borrowing, discouraging banks from borrowing and thus reducing the growth of the money supply.
Moral suasion: Historical pressure exerted by the Fed to discourage banks from heavy borrowing.

3. Open Market Operations

Definition: The purchase and sale by the Fed of government securities in the open market.
Mechanism: * Purchase: The Fed buys securities, paying with new reserves. Increase in money supply = $\text{money multiplier} \times \Delta\text{reserves}$ . * Sale: The Fed sells securities, removing reserves from the system. Decrease in money supply = $\text{money multiplier} \times \Delta\text{reserves}$ .
Jurisdiction: The Treasury Department collects taxes and pays bills (but cannot print money to finance deficits). The Fed is a quasi-independent agency that buys and sells preexisting (outstanding) securities.

COMBATING INFLATION SUMMARY

To resolve internal inflation, the Central Bank (CB) should: 1. Reserve Ratio: Increase the reserve ratio to reduce the money supply. 2. Interest Rate (Discount Rate): Increase the rate to reduce the money supply. 3. Open Market Operations: Sell securities to reduce the money supply.

THE SUPPLY CURVE FOR MONEY

The money supply curve is represented graphically as a vertical line, indicating that the Fed determines the quantity of money supplied regardless of the interest rate.

QUESTIONS & DISCUSSION

Q: Which of the following refers to the liquidity property of money? * Options: a. Money is a good medium of exchange; b. Money is portable and comes in convenient denominations; c. Money is readily accepted and easily exchanged for goods. * A: d. All of the above.
Q: When you transfer $1,000 from your checking account to your savings account, what happens? * A: d. M2 will remain the same and M1 will decrease. (Rationale: Checking is in both M1 and M2; savings is only in M2. M1 drops, but the total M2 stays constant because it includes M1).
Q: On the T-account of a bank, which is true? * A: b. Deposits are an important liability.
Q: Assuming no leakages, what does a money multiplier of 10 mean? * A: d. Each additional dollar of reserves creates $10 of additional deposits.
Q: The preferred tool of the Federal Reserve for conducting monetary policy involves: * A: c. Open market operations.
Q: If the Fed wants to increase the money supply, it will: * A: c. Buy government securities in the open market.