Principals of Macroeconomics Chapter 16: The Monetary System

What is bartering?

  • Bartering: the exchange one good or service for another
  • Requires a double coincidence of wants: unlikely occurrence that two people each have a good the other wants.
  • Waste of resources: people spend time searching for others to trade with
  • Using money
    • Solves those problems
  • Money
    • The set of assets in an economy that people regularly use to buy goods and services from other people
  • Money has three functions:
  1. Medium of exchange
    • Item that buyers give to sellers when they want to purchase goods and services
  2. Unit of account
    • Yardstick people use to post prices and record debts
  3. Store of value: A store of value is an asset or commodity that maintains its purchasing power or value over time. It is a way to preserve wealth by holding assets that are expected to retain their value or appreciate in the future. Examples of stores of value include gold, real estate, and certain types of financial instruments such as government bonds.

Wealth: The total of all stores of value, including both money and nonmonetary assets

Liquidity: The ease with which an asset can be converted into the economy’s medium of exchange

The Kinds of Money

  • Commodity money: Money that takes the form of a commodity with intrinsic value

(The item would have value even if it were not used as money)

Examples:

  • Gold coins
  • Fiat money:
    • Money without intrinsic value, used as money because of government decree
    • The U.S. dollar

 \n Money in the U.S. Economy

Money stock: The quantity of money circulating in the economy

Currency:  Paper bills and coins in the hands of the (non-bank) public

Demand deposits: Balances in bank accounts that depositors can access on demand by writing a check

 \n How to calculate M1 & M2

M1=

M2 = M1 + Savings deposits + Small time deposits + Money market mutual funds + A few minor categories.

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

  The Fed’s Organization

The Federal Reserve System consists of: Board of Governors (7 members, 14-year terms, located in Washington, DC Jerome Powell, Chair of the Fed, appointed in 2018 12 regional Federal Reserve Banks located around the U.S.)

The Fed’s Jobs

  1. Regulate banks and ensure the health of the banking system
    • Monitors each bank’s financial condition
    • Facilitates bank transactions (clearing checks)
    • A bank’s bank: makes loans to banks; lender of last resort
  2. Monetary policy by FOMC
    • Control the money supply: quantity of money available in the economy

The Federal Open Market Committee, FOMC

  • FOMC includes:
    • All 7 members of the Board of Governor
    • And 5 of the 12 regional bank presidents
    • All 12 regional presidents attend each FOMC meeting, but only 5 get to vote

Rules of Open-market operations, OMO:

  • Buy U.S. government bonds to increase the money supply
  • Sell U. S. government bonds to decrease the money supply

Bank Reserves

Fractional reserve banking system: Banks keep a fraction of deposits as reserves and use the rest to make loans.

  • The Fed establishes reserve requirements

    • Regulations on the minimum amount of reserves that banks must hold against deposits.
    • Banks may hold more than this minimum

  • The reserve ratio, R

  1. fraction of deposits that banks hold as reserves
  2. total reserves as a percentage of total deposits

The T-Account

  • T-account:  a simplified accounting statement that shows a bank’s assets and liabilities.

* Banks’ liabilities include deposits

*Assets include loans and reserves.

Changes in Money Supply

How did the money supply suddenly grow?

  • When banks make loans, they create money.
  • Isabella (the borrower) gets:
    • $800 in currency—an asset counted in the money supply
    • $800 in new debt (loans)—a liability that does not have an offsetting effect on the money supply

A fractional reserve banking system creates money, but not wealth.

The Money Multiplier

Money multiplier = 1/R: Amount of money the banking system generates with each dollar of reserves is the reciprocal of the reserve ratio

The higher the reserve ratio→ The smaller the money multiplier because the less of each deposit banks loan out

A More Realistic Balance Sheet

  • Assets:  Reserves, loans, securities (stocks and bonds)
  • Liabilities:  Deposits, debt, and equity.
  • Leverage: The use of borrowed funds to supplement existing funds for investment purposes
  • Bank capital (owner’s equity): The resources a bank obtains by issuing equity to its owners

  = bank assets - bank liabilities

A More Realistic Balance Sheet

  • Capital requirements are designed to ensure that banks will have sufficient capital to repay the depositors and debtors.
  • A bank's “capital” is the difference between the total value of the bank's assets and its total deposits plus debt.
  • That is, the bank's capital is the money that would be left over if the bank were able to liquidate all of its assets to pay off all of its depositors and debtors.
  • Its intended goal is to protect the interests of the depositors.

Capital Requirement

Capital requirement: A government regulation that specifies a minimum amount of capital, Intended to ensure banks will be able to pay off depositors and debts

  • Financial crisis of 2008–2009
    • Banks find themselves with too little capital to satisfy capital requirements
    • Credit crunch: the shortage of capital induced the banks to reduce lending

The Fed’s Tools of Monetary Control

  • Fractional-reserve banking
    • Banks create money
    • The Fed’s control of the money supply is indirect

money supply = money multiplier Ă— bank reserves

  • The Fed can change the money supply by
    • Changing quantity of reserves
    • Changing the reserve ration and money multiplier

 \n Open-Market Operations

  • Open-Market Operations (OMOs):
    • The purchase and sale of U.S. government bonds by the Fed.
  • To increase bank reserves and the money supply:
    • The Fed buys a government bond from a bank
    • Pays by depositing new reserves in that bank’s reserve account.
    • With more reserves, the bank can make more loans, increasing the money supply

Fed Lending to Banks

  • Banks borrow from Fed’s discount window
    • Paying an interest rate called the discount rate
    • Increasing reserves in the banking system, and increasing the money supply
    • If the Fed lowers the discount rate:  encourages banks to borrow more, increasing the quantity of reserves and the money supply
  • Term Auction Facility (2007-2010)
    • Fed sets a quantity of reserves it will loan, then banks bid against each other for these loans.)

Fed Helps Financial Institutions in Trouble

  • The Fed lends to banks
    • Not only to control the money supply but also to help financial institutions when they are in trouble
    • 2008 and 2009, a fall in housing prices throughout the U.S.
    • Sharp rise in mortgage defaults and many financial institutions holding those mortgages ran into trouble
    • The Fed provided many billions of dollars in loans to financial institutions in distress.

How the Fed Influences the Reserve Ratio

  • The Fed sets reserve requirements:
    • Regulations on the minimum amount of reserves banks must hold against deposits.
    • Reducing reserve requirements would lower the reserve ratio and increase the money multiplier.
  • Paying interest on reserves, since Oct. 2008
    • When banks hold reserves at the Fed
    • Raising this interest rate would increase the reserve ratio, lower the money multiplier, and lower the money supply

Problems in Controlling the Money Supply

  • The Fed does not control:
    • The amount of money that households choose to hold as deposits in banks
    • The amount that bankers choose to lend
  • Yet, the Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.

The Federal Funds Rate

  • The federal funds rate
    • Interest rate at which banks make overnight loans to other banks
    • The lender has excess reserves and the borrower needs reserves
  • Decisions by the FOMC
    • To change the target for the federal funds rate are also decisions to change the money supply
  • A decrease in the target for federal funds rate
    • Means an expansion in the money supply