Key points Chapter 16 The Monetary System Mediums of exchange example paper notes coins debit cards are in themselves worthless no intrinsic value not valuable if not used as money Cash check or debit card receipts act as claims to goods and services in the future Money facilitates production and trade and allows people to specialize in what they do best in turn raising everyone s standards of living Money wealth but wealth is the total of all stores of value Money is the most liquid asset Credit cards are not a method of payment rather a method of deferring payment The responsibility of an economy that uses the system of fiat money falls on a regulation institution For example the U S has the Federal Reserve Fed Helicopter vacuum metaphor used for the complex workings of monetary policy The Fed s policy decisions are key determinants of the economy s rate of inflation in the long run and the economy s employment and production in the short run The behavior of banks influences the money supply and may sometimes even complicate the Feds job of controlling it If banks hold all deposits in reserves banks do not influence the money supply When the assets and the liabilities exactly balance in a statement it is called a balance sheet Reserve ratio is influenced both by government regulation and bank policy When banks hold only a fraction of deposits in reserve the banking system creates money The higher the reserve ratio the less of each deposit banks loans out and the smaller the Loans are a bank s assets money multiplier Capital is also known as owner s equity The financial crisis of 2008 2009 occurred because of a phenomenon known as credit crunch which refers to banks running low on capital and forced to reduce lending The Fed controls the money supply indirectly because banks play the primary role in the The Federal Deposit Insurance Corporation FDIC guarantees the safety of deposits at most The Federal Funds Rate has influence over other sorts of interest rates that are all Open market purchases lower the federal funds rate and open market sales raise the federal creation of money banks interconnected funds rate Glossary Barter system The exchange of one good or service for another Double coincidence of wants The unlikely occurrence that two people each have a good or Money The set of assets in the economy that people regularly use to buy goods and services service that the other wants from each other Money acts as A medium of exchange given from buyers to sellers in exchange of a good or A unit of account used to measure and record economic value A store of value used to transfer purchasing power from the present to the service future Liquidity The ease with which an asset can be converted into the economy s medium of Commodity money Money that takes the form of a commodity with intrinsic value Gold standard When an economy uses gold as money or money that is convertible into gold Fiat money Money without intrinsic value that is used as money because of government exchange decree Money stock The quantity of money circulating in the economy M1 Demand deposits travelers checks other checkable deposits currency M2 Savings deposits small time deposits money market mutual funds everything in M1 Currency The paper bills and coins in the hands of the public Demand deposits Balances in bank accounts that depositors can access on demand by writing a Central bank An institution designed to oversee the banking system and regulate the quantity check of money in the economy Money supply The quantity of money available in the economy Monetary policy The setting of the money supply by policymakers in the central bank Open market operation The purchase and sale of U S government bonds which has a great influence on money supply Reserves Deposits that banks have received but have not yet loaned out Fractional reserve banking A banking system in which banks hold only a fraction of deposits as reserves This fraction in known as the reserve ratio Reserve requirement The minimum amount of reserves that banks must hold Excess reserves When banks may hold reserves above the legal minimum amount They do this to prevent running out of cash Money multiplier The amount of money the banking system generates with each dollar of reserves It is the reciprocal of the reserve ratio Bank capital The resources a bank s owners have put into the institution Leverage The use of borrowed money to supplement existing funds for purposes of investment The leverage ratio is of the assets to bank capital Insolvent When a bank is unable to pay off its debt holders and depositors in full Capital requirement A government regulation specifying a minimum amount of bank capital Discount rate The interest rate on the loans that the Fed makes to banks Federal funds rate The interest rate at which banks make overnight loans to one another The Federal Reserve o Created in 1913 o Run by a Board of Governors 7 members appointed by the President and confirmed by the Senate 14 year terms Long terms to allow independence from long term political pressures Chairman 4 year term 12 regional Federal Reserve banks o Two main jobs Regulating banks maintain the health of the banking system being a bank s bank and also a lender of last resort Controlling the money supply o Monetary policy decided by the Federal Open Market Committee FOMC Includes the 7 governors and 5 of the 12 presidents of the regional banks o The Fed s tools for monetary control Influencing the quantity of reserves Buying selling bonds in open market operations Making loans to banks Influencing the reserve ratio money multiplier Regulating reserve requirements Paying interest on banks reserves o Problems that the Fed encounters in trying to control the money supply The amount of deposits that households choose to hold in banks is not controlled by the Fed The amount of money bankers choose to lend is not controlled by the Fed