Chapter 15 The Monetary System Harcourt Brace Company The Meaning of Money Money is the set of assets in the economy that people regularly use to buy goods and services from other people Harcourt Brace Company Three Functions of Money Medium of Exchange anything that is readily acceptable as payment Unit of Account serves as a unit of account to help us compare the relative values of goods Store of Value a way to keep some of our wealth in a readily spendable form for future needs Harcourt Brace Company The Two Types of Money Commodity Money something that performs the function of money and has alternative nonmonetary uses Examples Gold silver cigarettes Fiat Money something that serves as money but has no other important uses Examples Coins currency check deposits Harcourt Brace Company Money in the U S Economy Money Stock is the quantity of money circulating in the economy Different ways of measuring the money stock in the economy M1 M2 Harcourt Brace Company Measurement of Money The most familiar form of money used includes Coins Currency Check Deposits Travelers Checks Harcourt Brace Company M1 Measurement of Money A broader measure of money than M1 includes M1 Savings Deposits Small Time Deposits Money Market Mutual Funds and other minor categories Harcourt Brace Company M2 Where is All The Currency In 1996 there was about 380 billion of U S currency outstanding 1 900 in currency per person Location of outstanding currency may include Currency held abroad Currency held by illegal entities Currency held in businesses for transac tion purposes Harcourt Brace Company Quick Quiz List and describe the three functions of money Harcourt Brace Company The Federal Reserve The Federal Reserve Fed serves as the nation s central bank which is designed to oversee the banking system and regulate the quantity of money in the economy The Fed is a privately owned institution authorized in 1914 by Congress to ensure the health of the nation s banking system Harcourt Brace Company The Fed s Organization The Fed is run by its Board of Governors Seven members appointed by the President of the United States The Chairman of the Board is the most important position presiding directing and testifying about Fed policy She He is appointed by the President Harcourt Brace Company The Fed s Organization The Federal Reserve System is made up of the Federal Reserve Board in Washington D C and twelve regional Federal Reserve Banks Monetary policy is made by the Federal Open Market Committee Harcourt Brace Company Three Primary Functions of the Fed Regulate the private banking industry to make sure banks follow federal laws intended to promote safe and sound banking practices Act as a banker s bank making loans to other banks and as a lender of last resort Control of the supply of money i e Monetary Policy Harcourt Brace Company Money Supply Changes by the Fed Open Market Operations The primary way in which the Fed changes the money supply done through the purchase and sale of U S government bonds with newly printed money To increase the money supply the Fed buys government bonds from the public To decrease the money supply the Fed sells government bonds to the public Harcourt Brace Company Quick Quiz How does the Fed increase the supply of money in the economy Harcourt Brace Company Banks and The Money Supply The behavior of banks can influence the quantity of demand deposits in the economy and therefore the money supply Fractional Reserve Banking System The practice of holding a fraction of money deposited as reserves and lending out the rest Harcourt Brace Company Fractional Reserve Banking Deposits into a bank are recorded as both assets and liabilities Deposits that have been received but not lent out are called reserves The supply of money in the economy is affected by the amount of deposits that are kept in the bank as reserves and the amount that is lent out Loans become an asset to the bank Harcourt Brace Company Bank T Account Example First National Bank Assets Reserves 10 00 Liabilities Deposits 100 00 Loans 90 00 Total Assets 100 00 Harcourt Brace Company Total Liabilities 100 00 Bank T Account Example First National Bank Assets Reserves 10 00 Liabilities Deposits 100 00 Loans 90 00 Total Assets 100 00 Harcourt Brace Company Total Liabilities 100 00 A T Account illustrates the financial position of a bank that accepts deposits keeps a portion as reserves and lends out the rest Money Creation with Fractional Reserve Banking When a bank makes a loan from it s reserves the money supply increases When banks hold only a fraction of deposits in reserve banks create money The creation of money through loans does not create any wealth but allows banks to charge interest several times on the same bit of wealth Harcourt Brace Company The Money Multiplier When one bank loans money that money is generally deposited into another or the same bank thus creating more deposits and more reserves to be lent out The Money Multiplier is the amount of money that the banking system generates with each dollar of reserves Harcourt Brace Company The Money Multiplier First National Bank Assets Reserves 10 00 Liabilities Deposits 100 00 Loans 90 00 Total Assets 100 00 Total Liabilities 100 00 Harcourt Brace Company The Money Multiplier First National Bank Second National Bank Assets Assets Liabilities Reserves 9 00 Deposits 90 00 Reserves 10 00 Liabilities Deposits 100 00 Loans Loans 90 00 Total Assets 100 00 81 00 Total Liabilities 100 00 Harcourt Brace Company Total Assets 90 00 Total Liabilities 90 00 The Money Multiplier First National Bank Second National Bank Assets Assets Liabilities Reserves 9 00 Deposits 90 00 Reserves 10 00 Liabilities Deposits 100 00 Loans Loans 90 00 Total Assets 100 00 81 00 Total Liabilities 100 00 Harcourt Brace Company Total Assets 90 00 Total Liabilities 90 00 The Money Multiplier First National Bank Second National Bank Assets Assets Liabilities Reserves 9 00 Deposits 90 00 Reserves 10 00 Liabilities Deposits 100 00 Total Money Supply 190 00 Loans Loans 90 00 Total Assets 100 00 81 00 Total Liabilities 100 00 Harcourt Brace Company Total Assets 90 00 Total Liabilities 90 00 What determines the size of the money multiplier The money multiplier is the reciprocal of the reserve ratio With a reserve requirement R of 20 or 1 5 The multiplier will be 5 Harcourt Brace Company M 1 R Tools of Monetary Control The Fed has three instruments of monetary control Open Market Operations Buying and