chapter 14
CHAPTER 14: MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM
Learning Outcomes
17.1 Define money and discuss its functions.
17.2 Discuss definitions of different measures of the money supply.
17.3 Explain how banks create money.
17.4 Describe the money multiplier.
17.5 Describe the Federal Reserve System.
17.6 Explain tools the Federal Reserve uses to manage the money supply.
The Role of Money in an Economy
Without money, barter would be necessary for trade, complicating the exchange of goods and services.
Money simplifies trade and facilitates economic activity.
Definition of Money
Money is a set of assets regularly used to buy goods/services.
Currency (cash) constitutes money; wealth in stocks/bonds isn't directly usable as money.
Wealth and Liquidity
Wealth: Total of all value stores (money + nonmoney assets).
Liquidity: Ease of converting an asset into the medium of exchange.
Money is the most liquid asset; others vary in liquidity (e.g., stocks are liquid, real estate is not).
Functions of Money
Medium of Exchange: Used in transactions (e.g., buying a t-shirt).
Unit of Account: Standard for measuring economic value and prices.
Store of Value: Maintains purchasing power over time; however, inflation erodes value.
Types of Money
Commodity Money: Holds intrinsic value (e.g., gold).
Fiat Money: Has no intrinsic value; value derived from government decree (e.g., U.S. dollars).
The U.S. Money Supply
The money stock influences key economic variables.
Components:
Currency (bills/coins).
Demand deposits (bank account balances accessible on demand).
Measures of Money Supply
M1: Includes very liquid assets.
M2: Broader measure that includes M1 plus other near-money assets.
The Federal Reserve System
Purpose: Regulates fiat money systems and oversees banking.
Founded: 1913, in response to banking crises.
Governance: Run by a Board of Governors with long terms to ensure independence.
The Fed's Primary Roles
Regulating Banks: Ensures banking system health and acts as a lender of last resort.
Controlling Money Supply: Monetary policy is determined by the Federal Open Market Committee (FOMC) and influences the economy.
The Federal Open Market Committee (FOMC)
Composition: Board of Governors and regional bank presidents; only five vote at meetings.
Functions: Adjusts the money supply through open-market operations (buying/selling government bonds).
Banks and the Money Supply
Banks influence money supply; the reserve ratio determines how much money can be created.
Types of Banking Systems:
100-Percent-Reserve Banking: No money creation; all deposits are reserves.
Fractional-Reserve Banking: Banks only hold a fraction as reserves, allowing them to create more money through loans.
Money Multiplier Effect
The money multiplier indicates how much money is generated with each dollar in reserves.
Formula: Money Multiplier = 1 / Reserve Ratio.
Bank Capital and Leverage
Bank Capital: Difference between assets and liabilities; acts as a safety net for depositor funds.
Regulators enforce capital requirements based on asset risk levels.
The Fed’s Tools of Monetary Control
Open-Market Operations: Buy/sell government bonds to influence the money supply.
Fed Lending to Banks: Provides reserves to banks as needed through discounts.
Influencing Reserve Ratio
Reserve Requirements: Regulations that dictate minimum reserves banks must maintain.
Interest on Reserves: Fed pays interest on bank reserves; a tool to influence reserve holding behavior.
Monetary Policy Challenges
Fed cannot control deposit amounts households choose to keep in banks.
Banks may hold excess reserves rather than lending out deposits, affecting money creation.
Conclusion: Key Takeaways
Money serves as a medium of exchange, a unit of account, and a store of value.
Federal Reserve oversees the monetary system and adjusts the money supply via multiple tools.
Control of the money supply by the Fed is imperfect due to banking behavior.