The Money Supply

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The Money Supply The Federal Reserve System

• CHAPTER 11

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What is money?

• Anything generally accepted as a medium of
  exchange.
• Money is a means of payment or medium of exchange
  of which without results in trade by barter.
• Money is a store of value that can be used when
  desired.
• i.e. transporting purchasing power from one time
  period to another.

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• Money is a unit of account, that is, a consistent
  way of quoting prices.

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Commodity Fiat Money

• Commodity monies are those items used as money
  that also have an intrinsic value in some other
  use e.g. cigarettes.
• Fiat money, also known as token money is
  intrinsically worthless but has value because of
  its acceptability.
• The government takes steps to ensure this
  acceptability by declaring it to be legal tender.
• The government also avoids debasement by not
  printing too much to avoid losing its value.

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Different Measures of the Supply of Money in the
United States

• M1 is transactions money and is made up of
  currency held outside banks, demand deposits,
  travelers checks, and other checkable deposits.
• It is all the forms of money that can be directly
  used for transactions.
• M2 is bond money which includes near monies.
• these are close substitutes for transactions
  money.

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• Beyond M2 are measures that incorporate a wide
  variety of financial instruments that have some
  resemblance to money.

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The Private Banking System

• Banks and other financial institutions borrow
  from individuals or firms with excess funds and
  lend to those who need funds.
• The main types are commercial banks, savings and
  loan associations, life insurance companies, and
  pension funds.

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How Banks Create Money

• History -
• In the 15th 16th Centuries people used gold for
  money. The practice developed of leaving it with
  goldsmiths for safekeeping in exchange for a
  receipts. In time the receipts themselves came to
  be traded for goods. This was an early form of
  paper money. This works well as long as people
  are confident otherwise there could be a run.

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Modern banking System

• A banks assets are its loans, vaults cash, and
  deposits at the Federal Reserve (reserves).
• A banks liabilities are deposits owed to
  customers.
• Banks are legally required to hold a certain
  percentage of their deposit liabilities as
  reserves -
• the percentage is the required reserve ratio.

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• The Creation of Money
• occurs when when banks make loans. Banks can lend
  up to the amount of their excess reserves, and
  when a loan is made, a demand deposit is created
  for the borrower, which the borrower can then
  spend
• The money multiplier is
• the multiple by which deposits can increase for
  every dollar in reserve .

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The Federal Reserve System

• Fed was created in 1913 by an Act of Congress.
• It is made up of a Board of Governors and 12
  Federal Reserve Banks.
• Monetary policy is set by the Federal Open market
  Committee which sets goals for the money supply
  and interest rates and directs the Open Market
  Desk at the New York Federal Reserve Bank.

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• Federal Reserve Banks
• The 12 Federal Reserve banks in the Federal
  Reserve System represent different geographical
  areas (district) of the United States. Each bank
  publishes its own monthly letter or review that
  includes economic data about its region.
• The 12 banks by district are
• Boston (1), NY (2), Philadelphia (3), Cleveland
  (4), Richmond(5), Atlanta (6), Chicago (7), St.
  Louis (8), Minneapolis (9), Kansas City (10),
  Dallas (11), and San Francisco (12)

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Functions of the Fed

• While the crucial role of the Fed is to control
  the money supply it also performs several
  important functions for banks, including
• clearing interbank payments
• regulating the banking system
• assisting banks in a difficult financial position
• manages exchange rates and the nations foreign
  exchange reserves.

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How the Fed controls the Money Supply
Controlling the Reserves

• The Required Reserve ratio
• changes in the ratio affect how much banks can
  lend from their reserves.
• The Discount Rate is
• the rate of interest the Fed charges on loans to
  the Banks.
• Open Market Operations are
• the most significant tool for for controlling
  reserves.
• It refers to the Fed buying and selling Treasury
  securities on the open market.

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• Two branches of the government deal in government
  securities
• the Treasury sells securities to finance the
  deficit.
• the Fed buys and sells already outstanding
  Treasury securities to affect the amount of
  reserves.

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The Mechanics of Open Market Operations

• When the Fed sells securities it collects payment
  and the level of reserve decreases.
• The reverse happens with a purchase. Each
  business day the Open Market Desk in New York Fed
  buys or sells millions of dollars worth of
  securities.
• this is the preferred tool for controlling
  reserves because it can be used with some
  precision, it is extremely flexible, and the
  effect on the money supply is fairly predictable.