Chapter 16 The Monetary System 1 The Meaning of Money Money Set of assets of an economy Regularly used to buy G S from others Functions of money Medium of exchange o Item buyers give to sellers when they want to purchase G S Unit of account Store of value o Yardstick people use to post prices and record debts o Item that people can use to transfer purchasing power From present to future Ease with which an asset can be converted into the economy s medium of The Kinds of Money Money in the form of a commodity with intrinsic value e g gold cigarettes Liquidity exchange Commodity Money Intrinsic value Item would have value even if it were not used as money Gold Standard Gold as Money Or paper money convertible to gold Fiat Money Money w o intrinsic value Used as money b c of govt decree legal tender for all debts public and private Fiat order or decree Money Stock Currency Demand Deposits Money in the U S Economy Quantity of money circulating in the economy Paper bills and coins in the hands of the public Balances in bank accounts depositors can access on demand by writing a Chapter 16 The Monetary System 2 Measures of Money Stock check M1 M2 o Demand deposits traveler s checks o Other checkable deposits currency o Everything in M1 o Savings deposits small time deposits o Money market mutual funds o A few minor categories Two Measures of the Money Stock for the U S Economy Where is all the Currency Jan 2013 1 1 trillion currency outstanding Implies the avg adult holds about 4 490 of currency Much currency is held abroad used for imports exports Much currency is held by drug dealers tax evaders other criminals Currency is not a particularly good way to hold wealth Can be lost or stole doesn t earn interest The Federal Reserve System The Federal Reserve the Fed Chapter 16 The Monetary System 3 U S central bank est 1913 After a series of bank failures in 1907 Purpose to ensure the health of the nation s banking system Central Bank Institution designed to o Oversee the banking system o Regulate the quantity of money in the economy Board of Governors 7 members 14 year terms The Fed s Organization o Appointed by the president and confirmed by the Senate The Chairman Bush admin Ben Bernanke 2010 Janet Yellen o Directs the Fed staff o Presides over board meetings o Testifies regularly about Fed Policy in front of congressional committees o Appointed by the president 4 year term The Federal Reserve System Federal The Fed s Jobs Regulates banks and ensures the health of the banking system o Regional Feds o Monitors each bank s financial condition o Facilitates bank transactions clearing house clearing checks o Acts as a bank s bank o The Fed lender of last resort Control the money supply o Quantity of money available in the economy o Monetary policy By Federal Open Market Committee FOMC Money Supply Monetary Policy o Quantity of money available in economy o Setting of the money supply Federal Open Market Committee FOMC 7 members of the board of governors 5 12 regional bank presidents o All twelve regional presidents attend each FOMC meeting but only 5 vote Chapter 16 The Monetary System 4 Meets about every 6 weeks in Washington D C Discuss condition of the economy Consider changes in monetary policy Fed s Primary tool Open Market Operation Purchase sale of U S govt bonds FOMC increases money supply The Fed open market purchase FOMC decreases money supply The Fed open market sale Money Currency Demand Deposits Banks the Money Supply Can influence the quantity of demand deposits in the economy and the Behavior of banks money supply Reserves Deposits that banks have received but have not loaned out The simple case of 100 reserve banking All deposits are held as reserves o Banks do not influence the supply of money Fractional Reserve Banking Bank hold only a fraction of deposits as reserves Fractional Reserve Banking Reserve Ratio Fraction of deposits that banks hold as reserves Reserve requirement Minimum amount of reserves that banks must hold set by the Fed Excess Reserve Banks may hold reserves above the legal minimum Example First National Bank Chapter 16 The Monetary System 5 o Reserve ratio of 10 The Money Multiplier Banks hold only a fraction of deposits in reserve Banks create money o Assets o Liabilities Increase in money supply o Does not increase wealth The Money Multiplier Amount of money the banking system generates with each dollar of reserves Reciprocal of the reserve ratio 1 R The money multiplier o Original deposit 100 00 o First National lending 90 00 9 100 00 o Second National lending 81 00 9 90 00 o Third National lending 72 90 9 81 00 o o Total money supply 1 000 00 Higher reserve ratio smaller money multiplier Bank Capital Resources a bank s owners have put into the institution Used to generate profit Chapter 16 The Monetary System 6 Financial Crisis of 2008 2009 Leverage investment firm Using borrowed money to supplement existing funds for purposes of High leverage more debt than available capital increases riskiness of the Leverage Ratio value of assets value of bank s capital Ratio of assets to bank capital Capital Requirement Govt regulation specifying minimum amount of bank capital If bank s assets rise in value of 5 1000 of assets 1050 B c some of the securities the bank was holding rose in price bank capital 50 100 finance definition of shares so for a leverage rate of 20 o a 5 increase in the value of assets increases the owners equity by 100 If bank s assets are reduced in value by 5 b c some people who borrowed from the bank default on their loans 1 000 assets 950 value of owners equity 0 So for a leverage ratio of 20 o 5 fall in the value of the bank assets o Leads to a 100 fall in bank capital If bank s assets are reduced in value by more than 5 B c some people who borrowed from the bank default on their loans For a leverage ratio of 20 o The bank s assets would fall below it s liabilities o The bank would be insolvent Unable to pay off its debt holders and depositors in full Chapter 16 The Monetary System 7 Many Banks in 2008 and 2009 Incurred sizable losses on some of their assets o Mortgage loans and securities backed by mortgage loans Shortage of capital induced the banks to reduce lending o Credit crunch o Contributed to ta severe downturn in economic activity U S Treasury and the Fed Put billions of dollars of public funds into the banking system o Increase the amount of bank capital Temporarily made the U S taxpayer a part owner of many banks Goal to