Chapter 14 Study Notes on Money, Banks, and the Federal Reserve
Chapter 14: Money, Banks, and the Federal Reserve System
Principles of Macroeconomics
The Meaning of Money
Definition of Money:
Money is defined as a set of assets in an economy that people regularly use to buy goods and services from others.
Asset: An asset is anything of value that is owned by a person or a firm, with examples including seashells, cigarettes, etc.
Functionality of an Economy Without Money:
It is possible for an economy to function without money by utilizing a Barter Economy.
In a barter economy, goods are traded for other goods rather than using money.
Problems with a Barter Economy:
Double Coincidence of Wants: This is the requirement that both parties in the trade value the goods offered by the other sufficiently to agree to an exchange.
Need for Money
Money is essential because it:
Makes trading easier.
Allows for specialization among producers and facilitates economic efficiency.
Functions of Money
The four main functions of money are:
Medium of Exchange: An item that buyers give to sellers when they want to purchase goods and services.
Example: Paying for groceries with cash.
Unit of Account: A yardstick people use to post prices and record debts.
Example: Price tags on goods.
Store of Value: An item that can be used to transfer purchasing power from the present to the future.
Example: Savings accounts, commodities like gold.
Standard of Deferred Payment: An item that people will accept for future payments of goods or services purchased today.
Criteria for What Can Serve as Money
Five criteria that an item must meet to serve as money:
Must be acceptable to most people.
Should be of standardized quality.
Should be durable.
Should be valuable relative to its weight.
Should be divisible for ease of exchange.
Types of Money
1. Commodity Money
Definition: Money that takes the form of a commodity with intrinsic value.
Examples: Gold coins, cigarettes in POW (Prisoner of War) camps.
2. Fiat Money
Definition: Money that has no intrinsic value and is used as money because of government decree.
Example: The U.S. dollar.
Liquidity
Definition: Liquidity refers to the ease with which an asset can be converted into the economy’s medium of exchange.
Money in the U.S. Economy
1. Types of Money Supply
Currency: 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.
2. Measures of the Money Stock
M1:
Comprises demand deposits, traveler's checks, other checkable deposits, and currency.
As of February 2011, M1 is estimated at $1.9 trillion.
M2:
Includes everything in M1 plus savings deposits, small time deposits, money market mutual funds, and other minor categories.
As of February 2011, M2 is estimated at $8.9 trillion.
Distribution of Currency
In 2009, $862 billion currency was outstanding with an average adult holding about $3,653.
A significant portion of currency is held abroad or by criminals such as drug dealers and tax evaders.
Currency is not considered a good way to hold wealth since it can be lost, stolen, and does not earn interest.
The Federal Reserve System
1. Definition and Overview
Federal Reserve (Fed): The central bank of the United States, designed to oversee the banking system and regulate the money supply in the economy.
2. Banking Mechanics
Reserves: Deposits banks have received but have not loaned out.
Reserve Requirement: Minimum amount of reserves that banks must hold, set by the Fed.
Reserve Ratio: Fraction of deposits that banks hold as reserves.
Excess Reserves: Reserves that banks may hold above the legal minimum.
Fractional-Reserve Banking
1. Explanation
In a fractional-reserve banking system, banks hold only a fraction of deposits as reserves, enabling them to create money.
This process increases the money supply but does not increase overall wealth.
2. T-Account Analysis
T-account: A simplified accounting statement that shows a bank’s assets and liabilities.
Example:
FIRST NATIONAL BANK
Assets: Reserves, Loans
Liabilities: Deposits
3. Example of Banking Operations
First National Bank with a reserve ratio of 10% must keep 10% of deposits in reserve and can loan out the remaining 90%.
If a person deposits $100, the bank keeps $10 as reserve and loans out $90, generating a multiplier effect throughout the banking economy.
Multipliers and Money Creation
1. Simple Deposit Multiplier
The Simple Deposit Multiplier (SDM) calculates the amount of money the banking system generates with each dollar of reserves.
Formula: where R is the reserve ratio.
A higher reserve ratio results in a smaller money multiplier.
2. Money Supply Example
Suppose you deposit $5,000 into a bank with a reserve ratio of 10%:
a) Each side of the bank’s T-account increases by $5,000.
b) After keeping $500 as reserves, the bank loans $4,500 to Carl, who deposits it back into a bank.
c) Continuous lending creates an expansive money supply according to the formula: resulting in an overall increase in total money supply.
The Federal Funds Rate
Definition: The federal funds rate is the interest rate at which banks make overnight loans to each other.
Changes in the federal funds rate affect other interest rates, influencing economic activity.
Bank Runs and Money Supply Stability
1. Definition
Bank Runs: Occur when depositors suspect that a bank may become bankrupt, leading many to withdraw their money simultaneously.
This poses a significant problem for banks operating under fractional-reserve banking as they cannot satisfy all withdrawal requests due to not having all deposits on hand as cash reserves.
2. Historical Context
Examples include the Great Depression, where many banks closed due to simultaneous bank runs, leading to reduced bank lending and a contraction in the money supply.
Today, bank runs are less common due to government insurance programs like the Federal Deposit Insurance Corporation (FDIC), which guarantees deposit safety and enhances depositor confidence.
The Structure of the Federal Reserve
1. Organizational Components
The Fed includes:
Board of Governors: Comprises 7 members with 14-year terms, appointed by the president and confirmed by the Senate.
The Chairman directs the Fed staff and presides over meetings.
Example: Ben S. Bernanke was Chairman as of February 2006.
2. Regional Banks
The Federal Reserve System consists of 12 regional Federal Reserve Banks located in major cities across the U.S.
The Federal Reserve's Role
The Fed's roles include:
Monitoring and regulating the banking system to ensure its health.
Controlling the money supply via monetary policy, primarily through the Federal Open Market Committee (FOMC).
Financial Crisis of 2008–2009
1. Overview
Financial crisis resulted in a shortage of capital for banks due to significant asset losses, leading to a credit crunch.
2. Bank Capital
Definition: Bank capital refers to the funds contributed by the owners of the bank, used to generate profits.
3. Leverage and Regulation
Leverage: Use of borrowed funds to increase investment capacity.
Leverage Ratio: Ratio of assets to bank capital, regulated to ensure banks maintain a minimum capital requirement.
4. Market Reactions
A drop in asset values can cause banks to lose all their capital, necessitating government intervention to recapitalize banks to restore lending operations.
Fed's Tools of Monetary Control
1. Overview
The Fed employs three primary tools to manage the money supply:
Open Market Operations
Reserve Requirements
Discount Rate
2. Detailed Explanation of Tools
Open-market operations: Involve buying or selling U.S. government bonds to influence money supply.
Reserve requirements: Set the minimum reserves a bank must hold. An increase decreases the money supply, while a decrease increases it.
The discount rate: The interest rate at which banks borrow from the Fed – higher rates reduce the money supply while lower rates increase it.
Federal Funds Rate and Economic Stability
The Fed targets the federal funds rate, adjusting it through open-market operations to stabilize the economy.
Quantity Equation and Money
1. Irving Fisher's Quantity Equation
The quantity equation:
Where:
M = Money supply
V = Velocity of money
P = Price level
Y = Real output
2. Velocity of Money
Definition: The average number of times each dollar in the money supply is used in transactions.
The Quantity Theory of Money asserts that if velocity is constant, changes in money supply directly affect prices.
3. Inflation Predictions
From the quantity equation, one can derive that:
If the money supply grows faster than real GDP, inflation occurs.
Conversely, if it grows slower, deflation follows.
If it grows at the same rate, price stability is achieved.
4. Hyperinflation
Extremely high rates of inflation (hundreds or thousands of percentage points per year) lead to severe recessions and slow economic growth.
This exhaustive guide provides a detailed understanding of money, banking, and the role of the Federal Reserve, along with important historical and theoretical contexts for macroeconomic principles.