The Money Supply and The Federal Reserve System

1
Chapter 10

• The Money Supply and The Federal Reserve System
• What is money?
• How does is work?
• What does The Fed do?

2
What is Money?

• Money is not income or wealth
• Money is anything that is generally accepted as a
  medium of exchange
• 3 qualifications for money
• Medium of Exchange
• Store of Value
• Unit of Account

3
Money

• The barter system required a double coincidence
  of wants
• In order to buy something I needed to have an
  item I was will to part with and the other
  individual was willing to accept
• Medium of Exchange
• Anything that accepted for goods and services
• Gold and silver

4
Money

• Store of Value
• Money needs to have value tomorrow
• An asset that can transfer purchasing power into
  the future
• Paintings, Baseball Cards, Diamonds
• Needs to be easily exchanged

5
Money

• A unit of account
• A consistent way of quoting prices
• We use dollars, but we could quote things in
  terms of other goods

6
Types of Money

• Commodity Money
• Items used as money that have intrinsic value
• Fiat Money
• Money that is intrinsically worthless
• What is the U.S. dollar?

7
The U.S. Dollar

• From 1944 - 1971, Bretton Woods system, every
  country had a currency that was backed by gold
• You could exchange currency for gold/silver
• The gold standard
• Due to exchange rate issues and lack of monetary
  control
• US abandoned the gold standard
• US currency is worthless

8
The U.S. Dollar

• Legal Tender
• The U.S. Dollar is only used as money because the
  U.S. government declares it so.
• This allows The Federal Reserve the power to
  control the amount of money in the economy
• Currency debasement
• The decrease in the value of money that occurs
  when its supply is increased rapidly.

9
The Modern Banking System

• A brief review of accounting
• Assets liabilities Net Worth, or
• Assets Liabilities Net Worth
• A banks most important assets are its loans.
  Other assets include cash on hand (or vault cash)
  and deposits with the Fed.
• A banks liabilities are its debtswhat it owes.
  Deposits are debts owed to the banks depositors.

10
Measuring Money

• M1
• Currency Demand Deposits Travelers Checks
  Other Checkable Deposits
• The most liquid, called transaction money
• M2
• M1 Savings Accounts Money Market Accounts
  other near monies
• More broad and time dependent

11
Banking System

• Financial Intermediaries
• Mediate the transactions of saving and lending
• Provide a market for borrowers and creditors
• Banks and bank-like institutions
• Goal
• Banks are private companies and want to generate
  profits
• Banks generate profit by gathering individuals
  excess saving and making loans at a higher
  interest rate

12
How Banks Create Money

• T-Accounts

13
Creation of Money

• Reserves
• The deposits that a bank has at the Federal
  Reserve bank plus its cash on hand.
• The reserve rate is set by the Federal Reserve
• The central bank of the United States
• Banks create money by making loans
• The reserve rate determines how much money is
  created

14
Creation of Money

• Reserve Rate
• After the Great Depression banks were required to
  hold a certain portion of all deposits,
  fractional reserve banking system
• Required Reserve Rate
• The minimum amount banks have to hold
• Excess Reserves
• Any amount above the minimum
• If banks have 100 million in deposits and the
  reserve rate is 10
• Banks have to hold 10 of 100 million or 10
  million, but they can then loan out the remaining
  90 million

15
The Beginning

• The money creation process begins
• When the Fed inserts money into the economy
• When a bank decides to loan out excess reserves
• The system is more complicated
• Money is lost
• Underground activities
• Under the mattress

16
The Creation of Money

• The Fed deposits 100 into the banking system and
  there is a 20 reserve rate
• Bank 1 100 in deposit and must keep 20 in
  reserves
• They can loan 80, which in turn gets
  re-deposited
• Bank 2 80 in deposit and must keep 16 in
  reserves
• They can loan 64, which in turn gets
  re-deposited
• Bank 3 64 in deposit and must keep 12.80 in
  reserves
• They can loan 51.20, which in turn gets
  re-deposited

17
The Creation of Money

• If this process continues it will create 500 in
  money
• The Money Multiplier
• 1 / Reserve Rate
• 1 / .2 5
• The Money Supply
• Money Multiplier Initial Deposit
• 5 100 500

18
The Federal Reserve System
19
The Federal Reserve System
20
The Federal Reserve System

• The Federal Open Market Committee (FOMC)
• Sets goal concerning the money supply and
  interest rate
• The one in the news
• The Open Market Desk
• Carries out the actions of the FOMC

21
What does the Fed do?

• Clearing Inter-bank Payments
• How do banks receive funds from a check issued by
  another institution?
• Sets banking regulations and policies
• Controls mergers
• Ensures sound banking practices
• Sets reserve rate
• Lender of last resort
• Controls the money supply

22
Controlling the Money Supply

• Three methods
• Changing the reserve rate
• Changing the discount rate
• Conducting open market operations
• Most common

23
Reserve Rate

• Changes in the reserve rate effect the money
  multiplier
• A lower reserve rate allows banks to create more
  loans. This increases the money supply
• A higher reserve rate forces banks into holding
  more money. This decreases the money supply and
  could force banks to call in loans

24
Discount Rate

• The rate at which banks can borrow from the Fed
• An increase in the discount rate increases the
  cost of borrow, thus lowering the money supply
• Fed Funds Rate
• Most known, the rate at which banks can borrow
  from each other, guide for other interest rates
• Banks borrow from the Fed and other banks
• Actual reserves fall below required reserves

25
Discount Rate

• On January 9, 2003, the Fed announced a new
  procedure that sets the discount rate above the
  rate that banks pay to borrow in the private
  market. It is thus clear that the Fed is not
  using the discount rate as a tool to try to
  change the money supply on a regular basis.
• It is more expensive to borrow from The Fed

26
Open Market Operations

• The buying and selling of bonds
• When The Fed purchases bonds
• They trade money for the bond, which increases
  the money supply
• When The Fed sells bonds
• The trade a bond for money, which decreases the
  money supply
• The Fed is a large holder of bonds

27
Treasury verses The Fed

• Treasury collects taxes for the payment of
  government bills
• When the government over spends the Treasury
  needs to borrow money
• They issue bills and bonds which are sold to
  banks, individuals, institutions, and foreign
  countries
• Does this change the money supply
• No, the Treasury takes the money earned from
  selling the bonds and purchases goods themselves
• Like a reverse transfer payment

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Treasury verses The Fed

• The Fed
• Is a large holder of bonds, but they are
  purchased from the private holders not the
  government
• When the Fed sells bonds, instead of using the
  money to purchase goods and services, they hold
  onto the money.
• The money is pulled from circulation

29
Can the Government Create Money

• Why cant the government print money
• Currently the printing presses are used to
  replace old bills
• If the government decides to finance their
  spending by printing money, seignorage
• This leads to a devaluation of the currency
• Responsible for hyperinflations in many Latin
  American countries

30
Money Supply
Because The Fed controls the money supply, the
money supply curve is independent of the rate of
interest. It is used with Money Demand to
determine the rate of interest.
31

• Which field of economic theory does not require
  that we know anything about money?
• a. Microeconomics.
• b. Macroeconomics.
• c. Neither microeconomic nor macroeconomic theory
  requires that we know anything about money.
• d. None of the above. Both microeconomic and
  macroeconomic theory require that we know quite a
  bit about money.

32

• Which field of economic theory does not require
  that we know anything about money?
• a. Microeconomics.
• b. Macroeconomics.
• c. Neither microeconomic nor macroeconomic theory
  requires that we know anything about money.
• d. None of the above. Both microeconomic and
  macroeconomic theory require that we know quite a
  bit about money.

33

• Which of the following refers to the liquidity
  property of money?
• a. The fact that money makes a good medium of
  exchange.
• b. The fact that money is portable and comes in
  convenient denominations.
• c. The fact that money is readily accepted and
  thus easily exchanged for goods.
• d. All of the above.

34

• Which of the following refers to the liquidity
  property of money?
• a. The fact that money makes a good medium of
  exchange.
• b. The fact that money is portable and comes in
  convenient denominations.
• c. The fact that money is readily accepted and
  thus easily exchanged for goods.
• d. All of the above.

35

• When you transfer 1,000 from your checking
  account to your savings account, this transaction
  will
• a. Decrease both M1 and M2.
• b. Decrease M1 and increase M2.
• c. M1 will remain the same and M2 will increase.
• d. M2 will remain the same and M1 will decrease.

36

• When you transfer 1,000 from your checking
  account to your savings account, this transaction
  will
• a. Decrease both M1 and M2.
• b. Decrease M1 and increase M2.
• c. M1 will remain the same and M2 will increase.
• d. M2 will remain the same and M1 will decrease.

37

• On the T-account of a bank
• a. Reserves are on the liability side.
• b. Deposits are an important liability.
• c. Assets plus net worth equal liabilities.
• d. Assets are usually greater than liabilities
  plus net worth.

38

• On the T-account of a bank
• a. Reserves are on the liability side.
• b. Deposits are an important liability.
• c. Assets plus net worth equal liabilities.
• d. Assets are usually greater than liabilities
  plus net worth.

39

• Assuming there are no leakages out of the banking
  system, a money multiplier equal to 10 means
  that
• a. The reserve ratio equals 10.
• b. An additional 10 of reserves create one
  dollar of deposits.
• c. Each additional dollar of deposits creates 10
  of reserves.
• d. Each additional dollar of reserves creates 10
  of additional deposits.

40

• Assuming there are no leakages out of the banking
  system, a money multiplier equal to 10 means
  that
• a. The reserve ratio equals 10.
• b. An additional 10 of reserves create one
  dollar of deposits.
• c. Each additional dollar of deposits creates 10
  of reserves.
• d. Each additional dollar of reserves creates 10
  of additional deposits.

41

• The preferred tool of the Federal Reserve for
  conducting monetary policy involves
• a. Changes in the reserve requirement.
• b. Changes in the discount rate.
• c. Open market operations.
• d. Government spending and taxation.

42

• The preferred tool of the Federal Reserve for
  conducting monetary policy involves
• a. Changes in the reserve requirement.
• b. Changes in the discount rate.
• c. Open market operations.
• d. Government spending and taxation.

43

• If the Fed wants to increase the money supply, it
  will
• a. Increase the discount rate.
• b. Increase the reserve requirement.
• c. Buy government securities in the open market.
• d. Print money.
• e. Sell gold.

44

• If the Fed wants to increase the money supply, it
  will
• a. Increase the discount rate.
• b. Increase the reserve requirement.
• c. Buy government securities in the open market.
• d. Print money.
• e. Sell gold.

45
Review Terms and Concepts

• barter
• commodity monies
• discount rate
• excess reserves
• Federal Open Market Committee (FOMC)
• Federal Reserve System (the Fed)
• fiat, or token, money
• financial intermediaries
• legal tender
• lender of last resort
• liquidity property of money

• M1, or transactions money
• M2, or broad money
• medium of exchange, or means of payment
• money multiplier
• near monies
• Open Market Desk
• open market operations
• required reserve ratio
• reserves
• run on a bank
• store of value
• unit of account