1 ECON 2133 Class Outline 3 Chap 11 The Monetary System Money is Whatever people in an economy use to buy goods and services from one another pg 283 Many are not money But some can be quickly converted into money Such assets are said to be highly pg 286 How do we define measure the money supply M1 includes pg 288 289 in circulation 740 bil checking bals 350 bil Other checkable deposits 316 bil Travelers checks Total M1 7 bil 1413 bil M2 includes M1 1413 bil bals 3558 bil MMMF s 763 bil time deposits 100 000 e g CDs 1068 bil Total M2 Financial Intermediaries 6802 bil pg 290 291 Are institutions through which savers provide funds to borrowers banks S Ls Credit unions Insurance co s Pension plan mgmt co s etc 2 The banking system Public banks The central bank Federal Reserve the Fed the public banking sys Regulates the total Fractional reserve banking Public banks must hold a portion of their customers deposit balances as The age of total deposits which banks must hold is the RRR pg 292 With fractional reserve banking the potential total money supply MS 1 RRR x Total Reserves E g If the RRR 10 0 10 and Tot Ress 1000 then Tot MS 1 10 x 1000 10 000 The ratio 1 RRR is called the See pg 300 301 How fract res banking multiplies the MS Bank A gets a new deposit of 1000 If the RRR is 10 the bank must hold 100 of the deposit as reserves but 3 It can use the remaining 900 excess reserves to make a this 900 is new money Suppose the 900 loan check is deposited in Bank B That bank must hold 90 as reserves but can loan out the remaining 810 more And the process continues But where do new deposits come from What if Sue attorney pays Lew landscaper to care for her lawn Assume Sue s checking acct is with Bank A and Lew s is with Bank B Sue writes Lew a check for 100 which he deposits Bank B s deposits reserves and loan potential But these by exactly the same amount for Bank A So the size of the total MS doesn t change The total MS can change bank reserves are added to or taken from the public banking How can this happen Enter the Federal Reserve The Fed s key monetary controls 1 Required reserve ratio RRR For banks holding total deposits 49 3 mil RRR is 49 3 mil RRR is 2 Monetary control interest rates 4 30 08 Discount rate apr set by Fed Federal funds rate apr target 3 Open market operations OMO s 1 and 2 pg 305 306 3 pg 297 OMO s are the Fed s key monetary control tool 4 The Fed uses OMO s to change the monetary base available to the public banking system An OMO is when the Fed or U S Govt securities on the open bond market A buy the monetary base pg 297 300 A sale the monetary base pg 303 305 Example 1 Fed buys 50 mil of bonds from an insurance co 2 The 50 mil paid for the bonds is deposited in the ins co s checking account in Bank A note that a non monetary asset bonds has been turned into money the Fed s payment of 50 mil 3 Bank A holds 5 mil 10 as and then the rest 45 mil new money 4 Suppose the 45 mil loan is deposited in Bank B 5 Bank B holds mil loans out mil more new money 6 and etc pg 298 300 The total effect of an OMO MS MB x MM MS is total money supply MB is the monetary base bank reserves MM is the money multiplier 1 RRR So if the Fed makes a 50 mil open mkt buy the total potential increase in the MS is MS 50 mil x 1 10 mil pg 301 5 But if the Fed sells 50 mil of bonds Buyer s payment is debited from his her bank s account with the FRB money has been turned into a non monetary asset i e the money paid to the Fed is no longer in circulation in the economy Which means that the bank s reserves by 50 mil Study the explanation on pg 301 303 to understand that Ultimately the total MS will decrease by 500 mil MS 50 mil x 1 10 500 mil Summary Expansionary monetary policy Decrease the Decrease the and or rate Open mkt increase the MB Contractionary monetary policy the RRR the discount and or federal funds rate Open mkt decrease the MB Note In actuality the MM is always 1 RRR because 1 When the MS increases people tend to hold more money and vice versa 2 Banks may choose to hold excess reserves pg 305 FYI a recent FRB study concluded that the M1 money multiplier is approx 1 7 XXX Chap 11