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Date Created: 08/29/15
CHAPTER 16 THE MONETARY SYSTEM Money is the set of assets in an economy that people regularly use to buy good and services from other people 0 Money has three functions in the economy Medium of Exchange is an item that buyers give to sellers when they want to purchase goods and services Unit of Account is the yardstick people use to post prices and record debts Store Value is an item that people can use to transfer purchasing power from the present to the future Liquidity is the ease with which an asset can be converted into the economy s medium of exchange Commodity Money such as gold is money that takes the form of a commodity with intrinsic value The term intrinsic value means that the item would have value even if it were not used as money When an economy uses gold as money or uses paper money that is convertible into gold on demand it is said to be operating under a gold standard Fiat money such as paper bills is money without intrinsic value that is used as money because of government decree A fiat is an order or decree The quantity of money circulating in the economy is called the money stock Currency is the paper bills and coins in hands of the public Demand deposits are the balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a store The important point is that the money stock for the US economy includes not just currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services M1 Demand deposits Traveler s checks Other checkable deposits Currency M2 Saving deposits Small time deposits Money market mutual funds A few minor categories Everything in M1 The Federal Reserve is the central bank of the United States is responsible for regulating the US monetary system It was created in 1913 it is run by its board of governors which has seven members appointed by the president and confirmed by the Senate The governors have fourteenyear terms The Federal Reserve System is made up of the Federal Reserve Board in Washington DC and twelve regional Federal Reserve Banks located in major cities around the country The Fed has two jobs oz To regulate banks and ensure the health of the banking system 393 To control the quantity of money that is made available in the economy called the money supply the quantity of money available in the economy The chairman directs the Fed staff presides over board meetings and testifies regularly about Fed policy in front of congressional committees The Central Bank is an institution designed to oversee the banking system and regulate the quantity of money in the economy Monetary policy is the setting of the money supply by policymakers in the central bank The Federal Open Market Committee is made up of the seven members of the board of governors and five of the twelve regional bank presidents Fed s primary tool is the openmarket operation the purchase and sale of US government bonds If the FOMC decides to increase the money supply the Fed creates dollars and uses them to buy government bonds from the public in the nations bond markets After the purchase these dollars are in the hands of the public Thus an openmarket purchase of bonds by the Fed increases the money supply Conversely if the FOMC decides to decrease the money supply the Fed sells government bonds from its portfolio to the public in the nation s bond markets After the sale the dollars it receives for the bonds are out of the hands of the public Thus an openmarket sale of bonds by the Fed decreases the money supply Reserves are deposits that banks have received but have not loaned out 100percentreserve banking is a system when deposits are held as reserves lf banks hold all deposits in reserve banks do not influence the supply of money Fractionalreserve banking is a banking system in which banks hold only a fraction of deposits as reserves Reserve requirements are when the Fed sets a minimum amount of reserves that banks must hold Excess reserves are when banks hold reserves above the legal minimum Reserve ratio is the fraction of deposits that banks hold as reserves When banks hold only a fraction of deposits in reserve banks create money 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 If R is the reserve ratio for all banks in the economy then each dollar of reserves generates 1R dollars of money The higher the reserve ration the less of each deposit bank loan out and the smaller the money multiplier Bank capital the resources a bank s owners have put into the institution Leverage is the use of borrowed money to supplement existing funds for purposes of investment Leverage ratio is the ratio of assets to bank capital Capital requirement is a government regulation specifying a minimum amount of bank capital The Fed has a variety of tools in its monetary toolbox 3 Those that influence the quantity of reserves The first way the Fed can change the money supply is by changing the quantity of reserves The Fed alters the quantity of reserves in the economy either by buying or selling bonds in openmarket operations or by making loans to bank Openmarket operations is the purchase and sale of US government bonds by the Fed The Fed can also increase the quantity of reserves in the economy by lending reserves to banks Banks borrow from the Fed when they feel they do not have enough reserves on hand to satisfy bank regulators meet depositor withdrawals make new loans or for some other business reason Discount rate is the interest rate on the loans that the Fed makes to banks 3 Those that influence the reserve ratio and thereby the money multiplier The Fed changes the money supply by influencing the reserve ratio and thereby the money multiplier The Fed can influence the reserve ratio either through regulating the quantity of reserves banks must hold or through the interest rate that the Fed pays banks on their reserves Reserve requirements is regulations on the minimum amount of reserves that banks must hold against deposits Paying interest on reserves Traditionally banks did not earn any interest on the reserves they held In October 2008 however the Fed began paying interest on reserves Federal funds rate is the interest rate at which banks make overnight loans to one another Whenever we buy or sell anything we are relying on the extraordinarily useful social convention called money
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