Chapter 10 The Money Supply and the Federal Reserve System An Overview of Money Money is a means of payment a store of value and a unit of account o A means of payment medium of exchange Barter the direct exchange of good and services for other goods and services requires a double coincidence of wants for trade to take place Medium of exchange means of payment what sellers generally accept and buyers generally use to pay for goods and services o A store of value A 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 o A unit of account 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 ex gold Fiat money aka token money items designated as money that are intrinsically worthless ex US money o Legal tender money that a government has required to be accepted in settlement of debts o Currency debasement the decrease in the value of money that occurs when its supply is increased rapidly M1 or transactions money money that can be directly used for transactions currency held outside banks demand deposits traveler s checks other checkable deposits stock variable has time units M2 or broad money M1 savings accounts money market accounts other near monies o Near monies close substitutes for transactions money such as savings accounts and money market accounts 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 o Commercial banks savings and loan associations life insurance companies pension fends How Banks Create Money Run on a bank occurs when many of those who have claims on a bank deposits present them at the same time Assets liabilities net worth Assets liabilities net worth Assets are things a firm owns that are worth something Federal Reserve Bank the Fed the central bank of the US Net worth represents the value of the firm to its stockholders or owners Reserves the deposits that a bank has at the Federal Reserve bank plus its Liabilities debts what it owes 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 When a bank has no excess reserves and thus can make no more loans it is When loans are converted into deposits the supply of money can change An increase in bank reserves leads to a greater than one to one increase in required reserves said to be loaned up the money supply o 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 required reserve ratio o Required reserve ratios depend on the size of the bank and the type of o Money multiplier is derived under the assumption that banks hold no deposit excess reserves The Federal Reserve System Board of governors most important group within the Federal Reserve System consists of 7 members each appointed for 14 years by the President chair of the fed is appointed for 4 years US is divided into 12 Federal Reserve districts each district has its own Federal Reserve bank Federal Open Market Committee FOMC consists of 7 members of the Fed s Board of Governors president of the NY Federal Reserve Bank and 4 out of the 11 presidents of other district banks sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in NY o Open Market Desk the office in the NY Federal Reserve Bank from which government securities are bought and sold by the Fed Functions of the Fed control the money supply clearing interbank payments regulating the banking system assisting banks in a difficult financial position managing exchange rates and the nation s foreign exchange reserves inter country negotiations controls mergers among banks examine banks to ensure that they are financially sound sets reserve requirements 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 The Fed has taken a much more active role in financial markets since 2008 Traditional assets of the Fed US treasury securities New assets of the Fed federal agency debt securities and mortgage backed securities How the Federal Reserve Controls the Money Supply If the Fed wants to increase the supply of money it creates more reserves thereby freeing banks to create additional deposits by making more loans To change the money supply the Fed can o 1 Change the required reserve ratio Decreasing the RRR increases money supply o 2 Change the discount rate Discount rate the interest rate that banks pay to the Fed to Banks borrowing from the Fed leads to an increase in the Higher discount rate higher the cost of borrowing restricting borrow from it money supply the money supply Moral suasion the pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed o 3 Engage in open market operations 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 Treasury department is responsible for collecting taxes and paying the federal government s bills If the Fed can reduce the volume of bank reserves on the liabilities side of its balance sheet it will force banks to reduce they own deposits decreases money supply The fed can expand the money supply by buying government securities from ppl who own them and can reduce the money supply by selling these securities Gov uses open market operations to control the money supply the most bc 1 It can be used with precision can change the money supply by a small amount 2 Extremely flexible 3 Fairly predictable effect on the supply of money Fed can create money at will Supply curve for money is vertical
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