ECON 104 11th Edition Exam 2 Study Guide Lectures 12 20 Lecture 12 October 27 Lecture 13 October 29 Lecture 14 November 3 and Lecture 15 November 5 The Money Supply and the Federal Reserve System Chapter 10 An Overview of Money o What is Money o Commodity and Fiat Monies o Measuring the Supply of Money in the United States o The Private Banking System How Banks Create Money o A Historical Perspective Goldsmiths o The Modern Banking System o The Creation of Money o The Money Multiplier The Federal Reserve System o Functions of the Federal Reserve o Expanded Fed Activities Beginning in 2008 o The Federal Reserve Balance Sheet How the Federal Reserve Controls the Money Supply o The Required Reserve Ratio o The Discount Rate o Open Market Operations o Excess Reserves and the Supply Curve for Money Definitions Money A means of payment a store of value and a unit of account Barter The direct exchange of goods and services for other goods and services o A barter system requires a double coincidence of wants for trade to take place That is to effect a trade you have to find someone who has what you want and that person must also want what you have Medium of Exchange What sellers generally accept and buyers generally use to pay for goods and services 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 Unit of Account A standard unit that provides a consistent way of quoting prices 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 M1 Transactions of Money Money that can be directly used for transactions o M1 currency held outside banks demand deposits traveler s checks other checkable deposits Near Monies Close substitutes for transactions money such as savings accounts and money market accounts M2 Broad Money M1 plus savings accounts money market accounts and other near monies o M2 M1 savings accounts money market accounts other near monies 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 Federal Reserve Bank The Fed The central bank of the United States 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 Excess Reserves The difference between a bank s actual reserves and its required reserves o Excess reserves actual reserves required reserves Money Multiplier The multiple by which deposits can increase for every dollar increase in reserves equal to 1 divided by the required reserve ratio 1 money multiplier required reserve ratio o Federal Open Market Committee FOMC A group composed of the seven members of the Fed s Board of Governors the president of the New York Federal Reserve Bank and four of the other 11 district bank presidents on a rotating basis it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York o The United States is divided into 12 Federal Reserve districts each with its own Federal Reserve bank The district banks are like branch offices of the Fed in that they carry out the rules regulations and functions of the central system in their districts and report to the Board of Governors on local economic conditions Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed Lender of Last Resort One of the functions of the Fed It provides funds to troubled banks that cannot find any other sources of funds Open Market Operations The purchase and sale by the Fed of government securities in the open market a tool used to expand or contract the amount of reserves in the system and thus the money supply o When the Fed purchases a security it pays for it by writing a check that when cleared expands the quantity of reserves in the system increasing the money supply When the Fed sells a bond private citizens or institutions pay for it with their bank deposits which reduce the quantity of reserves in the system o The Treasury Department is responsible for collecting taxes and paying the federal government s bills To finance the deficit G T is the amount the Treasury must borrow each year This means that the Treasury cannot print money to finance the deficit o The Fed is not the Treasury It is a quasi independent agency authorized by Congress to buy and sell outstanding preexisting U S government securities on the open market We can sum up the effect of these Open Market Operations this way o An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves o An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves Diagrams The Supply of Money Summary From the Lectures Lets Think About the Debt a Debt Servicing The interest required to be paid each year on outstanding debt b Opportunity Cost The cost of an alternative that must be forgone in order to pursue a certain action Put another way the benefits you could have received by taking an alternative action Bonds and Interest Rates c Bond A debt investment in which an investor loans money to an entity corporate or governmental that borrows the funds for a defined period of time at a fixed interest rate d Interest Rate The amount charged expressed as a percentage of principal by a lender to a borrower for the use of assets e Bonds and Interest Rates share an inverse relationship i When Price P of Bonds increase Interest Rates r decrease vice versa f The Federal Government regulates spending by the buying selling of Treasury Bonds Investment People who invest for the long term buy bonds for security while people who invest for the Short Term buy bonds for the