11 The Monetary System

THE MEANING OF MONEY

Money is the set of assets in an economy that people regularly use to buy goods and services from other people.

The Functions of Money

Money has three functions in the economy:

Medium of exchange

Unit of account

Store of value

Medium of Exchange

A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services.

A medium of exchange is anything that is readily acceptable as payment.

Unit of Account

A unit of account is the yardstick people use to post prices and record debts.

Store of Value

A store of value is an item that people can use to transfer purchasing power from the present to the future.

Liquidity

Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.

The Kinds of Money

Commodity money takes the form of a commodity with intrinsic value.

Examples: Gold, silver, cigarettes.

Fiat money is used as money because of government decree.

It does not have intrinsic value.

Examples: Coins, currency, check deposits.

Money in the U.S. Economy

Currency is the paper bills and coins in the hands of the public.

Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

Figure 1 Money in the U.S. Economy

CASE STUDY: Where Is All The Currency?

In 2001 there was about $580 billion of U.S. currency outstanding.

That is $2,734 in currency per adult.

Who is holding all this currency?

Currency held abroad

Currency held by illegal entities

THE FEDERAL RESERVE SYSTEM

The Federal Reserve (Fed) serves as the nation’s central bank.

It is designed to oversee the banking system.

It regulates the quantity of money in the economy.

The Fed was created in 1914 after a series of bank failures convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system.

The Structure of the Federal Reserve System:

The primary elements in the Federal Reserve System are:

1) The Board of Governors

2) The Regional Federal Reserve Banks

3) The Federal Open Market Committee

The Fed’s Organization

The Fed is run by a Board of Governors, which has seven members appointed by the president and confirmed by the Senate.

Among the seven members, the most important is the chairman.

The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees.

The Board of Governors

Seven members

Appointed by the president

Confirmed by the Senate

Serve staggered 14-year terms so that one comes vacant every two years.

President appoints a member as chairman to serve a four-year term.

The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks.

The Federal Reserve Banks

Twelve district banks

Nine directors

Three appointed by the Board of Governors.

Six are elected by the commercial banks in the district.

The directors appoint the district president, which is approved by the Board of Governors.

The New York Fed implements some of the Fed’s most important policy decisions.

The Federal Open Market Committee (FOMC)

Serves as the main policy-making organ of the Federal Reserve System.

Meets approximately every six weeks to review the economy.

The Federal Open Market Committee (FOMC) is made up of the following voting members:

The chairman and the other six members of the Board of Governors.

The president of the Federal Reserve Bank of New York.

The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis).

Monetary policy is conducted by the Federal Open Market Committee.

Monetary policy is the setting of the money supply by policymakers in the central bank

The money supply refers to the quantity of money available in the economy.

The Federal Open Market Committee

Three Primary Functions of the Fed

Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices.

Acts as a banker’s bank, making loans to banks and as a lender of last resort.

Conducts monetary policy by controlling the money supply.

Open-Market Operations

The money supply is the quantity of money available in the economy.

The primary way in which the Fed changes the money supply is through open-market operations.

The Fed purchases and sells U.S. government bonds.

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.

BANKS AND THE MONEY SUPPLY

Banks can influence the quantity of demand deposits in the economy and the money supply.

Reserves are deposits that banks have received but have not loaned out.

In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

Reserve Ratio

The reserve ratio is the fraction of deposits that banks hold as reserves.

Money Creation with Fractional-Reserve Banking

When a bank makes a loan from its reserves, the money supply increases.

The money supply is affected by the amount deposited in banks and the amount that banks loan.

Deposits into a bank are recorded as both assets and liabilities.

The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.

Loans become an asset to the bank.

This T-Account shows a bank that…

accepts deposits,

keeps a portion
as reserves,

and lends out
the rest.

It assumes a
reserve ratio
of 10%.

When one bank loans money, that money is generally deposited into another bank.

This creates more deposits and more reserves to be lent out.

When a bank makes a loan from its reserves, the money supply increases.

The Money Multiplier

How much money is eventually created in this economy?

The money multiplier is the amount of money the banking system generates with each dollar of reserves.

The money multiplier is the reciprocal of the reserve ratio:

M = 1/R

With a reserve requirement, R = 20% or 1/5,

The multiplier is 5.

The Fed’s Tools of Monetary Control

The Fed has three tools in its monetary toolbox:

Open-market operations

Changing the reserve requirement

Changing the discount rate

Open-Market Operations

The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:

When the Fed buys government bonds, the money supply increases.

The money supply decreases when the Fed sells government bonds.

Reserve Requirements

The Fed also influences the money supply with reserve requirements.

Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

Changing the Reserve Requirement

The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out.

Increasing the reserve requirement decreases the money supply.

Decreasing the reserve requirement increases the money supply.

Changing the Discount Rate

The discount rate is the interest rate the Fed charges banks for loans.

Increasing the discount rate decreases the money supply.

Decreasing the discount rate increases the money supply.

Problems in Controlling the Money Supply

The Fed’s control of the money supply is not precise.

The Fed must wrestle with two problems that arise due to fractional-reserve banking.

The Fed does not control the amount of money that households choose to hold as deposits in banks.

The Fed does not control the amount of money that bankers choose to lend.

Summary

The term money refers to assets that people regularly use to buy goods and services.

Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value.

Commodity money is money that has intrinsic value.

Fiat money is money without intrinsic value.

The Federal Reserve, the central bank of the United States, regulates the U.S. monetary system.

It controls the money supply through open-market operations or by changing reserve requirements or the discount rate.

When banks loan out their deposits, they increase the quantity of money in the economy.

Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.