Key Concepts of Money Supply and Banking

Functions of Money
  • Medium of Exchange: An item buyers give to sellers when they buy goods and services (g&s).
  • Unit of Account: The yardstick used to post prices and record debts, providing a standard measure.
  • Store of Value: An item that can be used to transfer purchasing power from present to future, preserving value over time.
Types of Money

  • Commodity Money:

    • Takes the form of a commodity with intrinsic value.
    • Examples: Gold coins, cigarettes in POW camps.

  • Fiat Money:

    • Money without intrinsic value, used as money due to government decree.
    • Example: The U.S. dollar.
Money Supply
  • Money Supply (Money Stock): The total quantity of money available in the economy.
  • Components of Money Supply:
    • Currency: Paper bills and coins in the hands of the public (excluding banks).
    • Demand Deposits: Balances in bank accounts that depositors can access on demand by writing checks.
Measures of the U.S. Money Supply

  • M1:

    • Includes currency, demand deposits, traveler’s checks, and other checkable deposits.
    • M1 (October 2005): $1.4 trillion.

  • M2:

    • Includes everything in M1 plus savings deposits, small time deposits, and money market mutual funds.
    • M2 (October 2005): $6.6 trillion.

  • Note: Distinction between M1 and M2 typically is not crucial in many discussions of the money supply.

Central Banks & Monetary Policy
  • Central Bank: Institution that oversees the banking system and regulates the money supply.
  • Monetary Policy: The actions of policymakers at the central bank to manage the money supply.
  • Federal Reserve (Fed): The central bank of the U.S., responsible for monetary policy.
Bank Reserves
  • In a fractional reserve banking system, banks retain a fraction of deposits as reserves and use the rest for loans.
  • The Fed sets reserve requirements, which dictate how much banks must hold as reserves against deposits.
  • Reserve Ratio (R): The fraction of deposits that banks hold as reserves, expressed as total reserves / total deposits.
Bank T-account
  • T-account: A simplified accounting statement that illustrates a bank's assets and liabilities.
    • Example:
    • Assets: Reserves $10
    • Liabilities: Loans $90, Deposits $100
    • Here, R = 10% ($10/$100).
Impact of Banks on Money Supply
  • Scenario 1: No banking system - Public simply holds currency. Money supply = $100.
  • Scenario 2: 100% reserve banking - Banks hold all deposits as reserves. Money supply remains at $100.
  • Scenario 3: Fractional reserve banking - Money supply grows.
    • If banks loan out funds, new deposits are created, increasing overall money supply.
    • Example: $100 reserves can generate $1000 due to the banking multiplier effect, depending on R.
Money Multiplier
  • Money Multiplier: The number of times money supply increases for each dollar of reserves.
  • Calculated as: extMoneyMultiplier=1Rext{Money Multiplier} = \frac{1}{R}.
  • With a reserve ratio of 10% (R = 0.1), the multiplier is 10.
  • Example: $100 of reserves creates $1000 of money supply.
Tools of Monetary Control by the Fed

  1. Open-Market Operations (OMOs):

    • Buying/selling government bonds.
    • To increase money supply, the Fed buys bonds, injecting money into the system.
    • To reduce, the Fed sells bonds, taking money out of circulation.

  2. Reserve Requirements (RR):

    • Dictate how much money banks can lend.
    • Lowering RR increases money supply; raising it reduces money supply.
    • Used infrequently due to potential disruption in banking.

  3. Discount Rate:

    • The interest rate on loans the Fed extends to banks.
    • Lowering this rate encourages banks to borrow more and increase lending, injecting money into the economy.
    • Raising the rate has the opposite effect.
The Federal Funds Rate
  • The rate at which banks lend reserves to each other overnight.
  • Changes in the federal funds rate influence other interest rates and impact the economy.
  • Targeting the federal funds rate is managed through OMOs by the FOMC (Federal Open Market Committee).
Problems Controlling the Money Supply
  • Holding currency instead of deposits reduces the amount banks have for loans, decreasing money supply.
  • Increased reserves held by banks can also decrease the money supply due to fewer loans.
Bank Runs and Money Supply
  • Bank Run: When depositors withdraw funds due to fears about the bank's stability.
  • In fractional-reserve systems, banks lack enough reserves to cover all withdrawals, potentially leading to bank closures.
  • Historical Context: Between 1929-1933, bank runs caused a significant drop in money supply, contributing to the Great Depression. Today, federal deposit insurance mitigates this risk.