ECON 2133 Class Outline 3Chap. 11 – The Monetary SystemMoney 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 $ 7 bil.Total M1 = $1413 bil.M2 includes . . .M1 $1413 bil.______________ bals. $3558 bil.MMMF’s $ 763 bil.“_________” time deposits $1068 bil.(<$100,000 – e.g. CDs)Total M2 = $6802 bil.Financial Intermediaries (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.1The banking systemPublic banks- - -The central bank (Federal Reserve – the “Fed”)- ___________ / ____________ the public banking sys.- Regulates the total _________________Fractional reserve bankingPublic 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 ReservesE.g.: If the RRR = 10% (0.10)and Tot. Ress. = $1000then Tot. MS = (1 / .10) x $1000 = $10,000The ratio (1 / RRR) is called the _____________________See pg. 300 – 301How fract. res. banking “multiplies” the MSBank A gets a “new” deposit of $1000. If the RRR is 10%, the bank must hold $100 of the deposit as reserves, but . . .2- 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 thepublic banking ___________.How can this happen?Enter the Federal ReserveThe Fed’s key monetary controls1. 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!3** 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)Example1. 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 B5. Bank B holds $_____ mil., loans out $______ mil (more new money)6. and etc. (pg. 298 – 300)The total effect of an OMO∆MS = ΔMB x MMMS is total money supplyMB 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 MSisΔMS = $50 mil. x (1 / .10) = $______ mil. (pg. 301)4But 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.ΔMS = - $50 mil. x (1 / .10) = - $500 mil.SummaryExpansionary 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) because1. 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. 1.7XXX Chap.