Money and the Monetary System

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Money and the Monetary System

• Outline
• The definition and functions of money
• Measuring the money supply
• Financial institutions
• The Federal Reserve system (the FED)
• The FEDs policy tools.

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What is money?
Money is anything that serves as a means of
payment or method of settling debts.
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Functions of Money?

• Money is a medium of exchange
• Money is a unit of account
• Money is a store of value or wealth

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Fiat Money Anything which serves as a means of
payment by government declaration
This Note Is Legal Tender For All Debts, Public
and Private
You are willing to accept money not because it is
backed by precious metals but rather because
you know it is generally acceptable in exchange
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What is liquidity?

• Liquidity refers to two properties of assets or
  stores of value, namely
• The ready convertibility of the asset to
  generalized purchasing power (or money)
• The comparative safety of the asset.

Money is the most liquid asset available under
normal circumstances
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The liquidity scale
Farmland, commercial real estate
Treasury bills, commercial paper
Ceramics, art, rugs, rare coins
Least liquid
Most liquid
Currency, checkable deposits
Government and corporate bonds, equities
Specialized equipment
Savings and time deposits
Home equity
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Deposits are MoneyBut Checks are Not
(a) Ricks Account at Delta Bank
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(b) The Flower Shops Account at Delta Bank
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Measuring the money supply
To measurethe moneysupply, we sum upassets to
the far rightof the liquidity spectrum
MostLiquid
Non-money assets
money
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M1
M1 includes

• Currency in circulation
• Demand deposits at commercial banks
• Travelers checks
• Other checkable deposits including NOW accounts,
  ATS accounts, and checkable deposits at credit
  unions and mutual savings banks

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Components of M1, July 17, 2000 (in billions)
OCDs means other checkable deposits.
Source Federal Reserve Bulletin
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M2
M2 includes M1 plus

• Savings deposits
• Small time deposits (less than 100,000)
• Retail money market mutual fund balances

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Components of M2, July 17, 2000 (in billions)
Source Federal Reserve Bulletin
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The Monetary System
The monetary system consists of the Federal
Reserve and the banks and other institutions that
accept deposits and provide the services that
enable people and businesses to make and receive
payments.
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Financial Institutions

• 3 types of institutions accept deposits that are
  a part of the nations money supply
• Commercial banks
• Thrift institutions
• Money market funds A financial institution that
  obtains funds by selling shares and uses these
  funds to purchase assets such as U.S. Treasury
  bills.

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U.S. Commercial Banks, 1997
Source FDIC
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Depository institutions are required by law
to hold a minimum fraction of their liabilities
on account at the FED

• Legislation
• Federal Reserve Act of 1913
• DIDMCA of 1982

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The Fractional Reserve System

• Reserves The currency in a banks vaults plus
  the balance on its reserve account at the Federal
  Reserve Bank.
• Required reserve ratio The minimum percentage of
  deposits that banks and other financial
  institutions must hold in reserves.
• Excess reserves Banks reserves that exceed those
  needed to meet the required reserve ratio.

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Federal Funds

• Banks that have excess reserves may loan them to
  banks with reserve deficiencies
• These loans are made in the interbank loan, or
  federal funds, market.
• The interest rate on loans in the interbank
  market is the federal funds rate.

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A Typical Bank Balance Sheet
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The Economic Functions of Monetary Institutions

• Create liquidity (money)
• Lower costs
• Pool risks
• Make payments

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The Federal Deposit Insurance Corporation (FDIC)

• Created in 1933
• A government agency that insures deposits in
  commercial banks (up to 100,000 per account).
• Banks pay premiums to the FDIC

Bank failureswere often a self-fulfilling
prophesy.
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Board of Governors 7 members appointed by the
President
Federal Open Market CommitteeBoard of Governors
plus 5 Federal Reserve Presidents
Appoint 3 directors
12 Federal Reserve Banks
Elect 6 directors
Organization of the Federal Reserve System
3,500 member commercial banks
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(No Transcript)
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Consolidated balance sheet of the Federal Reserve
system (August 31, 1999)
(in millions)
Source Federal Reserve Bulletin
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The instruments of monetary policy

• Reserve requirements
• The discount rate
• Open market operations

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Open market operationsare the purchase or sale
ofU.S. government securitieson the open market
by the Federal Reserve system
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The FED Open Market Committee is the unit in
charge ofopen market operations