GradeBuddy AEM 260 1ST EditionStudy Guide Lecture Chapters 16-19CHAPTER 16: THE MONETARY SYSTEM- Barter: the exchange of goods and services for other goods and serviceso Bartering would cause trouble in allocating scare resources efficiently- Trade is said to double coincidence of wants-the unlikely occurrence that twopeople each have goods and services that the other wants- Existence of money:o Makes trade easiero Allows people to specialize in what they do besto Raises standard of living- Money: the set of assets in an economy that people regularly use to buy goodsand services from other people- The 3 functions of money (distinguishes money from other assets)1. Medium of Exchange: an item that buyers give to sellers when they want to purchase goods and services2. Unit of Account: the yardstick people use to post prices and record debtsa. This way things are quoted in the same unit-not in terms of each other3. Store of Value: an item that people can use to transfer purchasing power from the present to the futurea. Non-monetary assets can do this as well (stocks and bonds)b. The term wealth is used to refer to the total of all stores of value-monetary and non monetary- Liquidity: the ease of which an asset can be converted into the economy’s medium of exchangeo Money is the most liquido Stocks and bonds relatively liquido Selling houses and other objects requires more effort and time which makes them less liquid- Commodity Money: money that takes the form of a commodity with intrinsic value (would have value even if it weren’t money)o Gold or cigarettes in prisono When an economy uses gold as money it is operating on the gold standard- Fiat Money: money without intrinsic value that is used as money because of government decree- Although government is central to establishing and regulating a system of fiatmoney, other factors are also required for the success of the monetary systemlike expectations and social convention- Money Stock: the quantity of money circulating in the economyo Powerful influence on many economic variablesGradeBuddy - What is part of the money stock?o Currency: the paper bills and coins in the hands of the publico Demand Deposits: balances in bank accounts that depositors can access on demand by writing a check- In a complex economy, such as ours, it is not easy to draw a line between assets that can be called “money” and assets that cannot- Two most common measures of money stock:o M1: demand deposits, Traveler’s checks, other checkable deposits, andcurrencyo M2: everything included in M1, savings deposits, small time deposits, money market mutual funds, and a few minor categorieso The important point is that the money stock includes more than just currency- Federal Reserve: 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 was created in 1913 after a series of bank failures in 1907o There was a need for a central bank to ensure health of the nation’s banking system- The Fed is run by its board of governors, which has 7 members appointed by the president and confirmed by the Senateo Governors serve 14-year terms-gives them independence from short-term political pressures when they formulate monetary policy- The chairman is the most important of the board of governorso Directs the Fed staff, presides over board meetings, and testifies regularly about Fed policy in front of congressional committees- President appoints chairman for 4-year terms- The Federal Reserve System is made up of the Federal Reserve Board in Washington DC and 12 regional Federal Reserve Banks- The presidents of the regional banks are chosen by each bank’s board of directors, whose members are typically drawn from the region’s banking and business community- The Fed has two related jobs:1. Regulate banks and ensure health of the banking systema. Monitors each bank’s financial condition and facilitates transactions by clearing checksb. Acts as a bank’s banki. The Fed makes loans to banks when banks themselves want to borrowii. The Fed acts as a lender of last resort-a lender to those who cannot borrow anywhere else-to maintain stability in the overall banking system2. Controls the quantity of money that is made available in the economy called money supplyGradeBuddy a. Monetary Policy: the setting of the money supply by policy makers in the central bankb. The monetary policy is made by the Federal Open Market Committee (FOMC). The FOMC meets about every 6 weeks in Washington DC to discuss the condition of the economy and changes in monetary policy- The FOMC is made up of the seven members of the board of governors and five of the twelve regional bank presidentso All twelve presidents attend meetings but only five get to voteo Voting rights rotate over timeo President of the New York Federal Reserve always gets to vote New York is the traditional trading center. All Fed purchases and sales of government bonds are conducted at the New York Fed’s trading desk- Through the FOMC, Fed has the power to increase or decrease the amount of dollars in the economy- The Fed’s primary tool is the open-market operation-the purchase and sale ofUS government bondso The FOMC can increase money supply by creating dollars and using them to buy government bonds from the public Dollars in the hands of the publico The FOMC can decrease money supply by selling government bonds tothe public Dollars out of the hands of the public- Changes in the money supply can profoundly affects the economyo Prices rise when the government prints too much moneyo Society faces a short-run trade off between inflation and unemployment- Power of Fed rests on these principles- Reserves: deposits that banks have received but not loaned out- Balance Sheet: a sheet that balances assets and liabilities - If banks hold all deposits in reserve, banks do not influence the supply of moneyo 100% reserve banking- Fractional Reserve Banking: a banking system in which banks hold only a fraction of deposits of reserves o Banks can make a profit off of interest paid by people that take out loans from the bank- Reserve Ratio: the fraction of deposits that banks hold as reserves- Reserve Requirement: minimum amount of reserves banks must hold- Excess Reserves: reserves held above the legal minimum- When banks hold only a fraction of deposits in reserve the banking system creates moneyGradeBuddy -