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Chapter 11 The Monetary System

by: Roger D.

Chapter 11 The Monetary System Econ 202 - 01

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These notes are from the 10th week of class. They cover the Monetary System. Sections are the Meaning of Money, The Federal Reserve System, Banks and the Money Supply and The Fed's Tools of Monet...
Principles Of Macroeconomics
Kwan Yong Lee
Class Notes
Econ, Economics, Macro, Macroeconomics, class, notes, study, guide, brief, Principles, gregroy, mankiw, 7th, edition
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This 11 page Class Notes was uploaded by Roger D. on Tuesday April 12, 2016. The Class Notes belongs to Econ 202 - 01 at University of North Dakota taught by Kwan Yong Lee in Spring 2016. Since its upload, it has received 19 views. For similar materials see Principles Of Macroeconomics in Economcs at University of North Dakota.


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Date Created: 04/12/16
Econ 202 Chapter 11 ~ THE MONETARY SYSYTEM 1 ~ THE MEANING OF MONEY The Prelude: Although paper-money has no “intrinsic” value, it still represents a claim to goods and services in the future. The use of paper-money is an efficient means of trade over bartering and the double-coincidence from finding the right person to trade goods and services with: Bartering is then an inefficient use of scarce resources, and especially one’s time spent. Money also allows a person to do those things which they are specialized at doing thusly increasing one’s standard of living. Money ~ is the set (type) of assets (items) in an economy that people regularly use to buy goods and services from each other: Money includes only those few types of wealth that are regularly accepted by sellers in exchange for goods and services. The 3 Functions of Money: 1. A Medium of Exchange ~ is an item that buyers give to sellers when they want to purchase goods and services. a. Money is a liquid asset because of its ease of conversion in exchanges of goods and services b. Money is the most liquid asset in the economy’s medium of exchange 2. A Unit of Account ~ is the yardstick people use to post prices and record debts a. Money is used to measure and record economic value 3. A Store of Value ~ is an item that people can use to transfer purchasing power from the present to the future; such as, stocks, bonds, CD’s, savings accounts and etc. a. Wealth ~ is used to refer to the total of all stores of value, including both money and nonmonetary assets Intrinsic Value ~ means that the “item” would have value even if it were not used as money; such as, gold or cigarettes used in economies where paper-money isn’t valued or available. Liquidity (liquid) ~ is the ease with which an asset can be converted into the economy’s medium of exchange. Commodity Money ~ is money which takes the form of a commodity with intrinsic value  Gold ~ 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 because of its intrinsic value  Cigarettes ~ used as value in certain economies because of its intrinsic value as a store of value, a unit of measure and a medium of exchange Demand Deposits ~ are balances in bank accounts that depositors can readily access on demand by writing out a check for payment of a good or service. Fiat Money ~ is money without any form of intrinsic or commodity value that is used as money because of a government decree. A federal dollar bill has on it “this note is legal tender for all debts, public and private.” Currency ~ is the paper bills and coins in the hands and pockets of the public which is most widely accepted and is extremely liquid. Money Stock ~ is the quantity of money circulating in the economy, and it also includes financial institutions that can be readily accessed and used to buy goods and services just like currency and bank deposits: M1 & M2 are 2 measures of the money stock in the U.S. economy.  M1 ~ currency, demand deposits, traveler’s checks and other checkable deposits  M2 ~ is M1 + savings deposits, small-time deposits, money market mutual funds and minor categories And where is all of the currency since we all should have $4,490 dollars on our persons?  The first explanation is that much of the currency is held abroad, because the U.S. dollar is the preferred currency to use; at the present time anyways.  The second explanation is that much of the currency is held by drug dealers, tax evaders and other criminals.  Holding a lot of currency is not a safe thing to do and can’t earn interest or grow wealth under one’s mattress. 2 ~ THE FEDERAL RESERVE SYSTEM Federal Reserve (Fed) ~ is the central bank of the United States: It is the central banking agency that regulates the money system and regulates the fiat banking system. Central Bank ~ is an institution designed to oversee the banking system and regulate the quantity of money in the economy. The Federal Reserve System (Organization)  7 members of its board of governors that are appointed by the president and confirmed by the senate, they have 14-year terms a. The chairman has a 4-year appointment, directs the Fed staff and is appointed by the president b. 12 regional federal reserve banks (rotational voting rights for 5 members in each meeting)  2 Functions of the Federal Reserve 1. Regulate banks and ensure the health of the banking system ~ the federal reserve is the “lender of last resort,” because financially troubled banks get loans from the “fed” as a bank’s bank 2. To control the quantity of the money supply in the economy via FOMC policies Money supply ~ is the quantity of money available in the economy; it is currency + demand deposits. Monetary policy ~ is the setting of the money supply by policymakers in the central bank FOMC (Federal Open Market Committee) ~ is made up of the 7 members of the board of governors and 5 of the 12 regional bank members which have voting rights at meetings. The FOMC meets approximately every 6 weeks. Their primary tool is the open-market operation (OMO). Open-Market Operation (OMO):  Buy bonds back from the public which increases the money supply  Sell bonds to the public which reduces the money supply  These policies determine the inflation rate and unemployment in the economy 3 ~ THE CENTRAL ROLE OF BANKS AND THE MONEY SUPPLY Money Stock ~ is the quantity of money circulating in the economy and includes both currency (bills and coins in your pockets) and demand deposits (the balance in your checking account). Reserves ~ are bank deposits that banks have received but have not loaned out.  100% reserve banking occurs when NO money is loaned out from reserves o Thus, if banks hold all deposits in reserve; banks do not influence the supply of money and are only depository institutions Balance Sheet ~ when the accounting balances exactly between assets and liabilities  Each deposit in the bank reduces currency (the bills and coins in your pockets) and raises demand deposits by exactly the same amount, leaving the money supply unchanged. Fractional-Reserve Banking ~ is a banking system in which banks hold only a fraction of deposits as reserves.  Reserve Ratio (R) ~ is the fraction of deposits that banks must hold as reserves as required by the Federal Reserve, and it equals total reserves as a percentage (%) of total deposits. ???????????????????????????????? o Reserve Ratio (R) = 100 × ???????????????????????? ???????????????????????????????? such as, 100 × R = 100 × 0.1 = 10% o Reserve Requirement (RR) ~ are regulations on the minimum amount of reserves set by the Federal Reserve that banks must hold against deposits. o Excess Reserves ~ are reserves which banks hold that are above the legal minimum of the reserve requirement. Money Supply ~ is the quantity of money available in the economy that is a combination of currency plus (+) demand deposits: It is increased by banks via fractional banking by making loans to businesses and the public. (MS = currency + demand deposits)  When the banks hold only a fraction of deposits in reserve, the banking system creates money  Wealth (purchasing power) is not created via this process, the loans serve as borrower debt Bank T-Account general definitions  Reserves + Loans = Deposits  Liabilities ~ are the depositor’s claims on the bank  Reserves ~ are the funds available to the bank which haven’t been loaned out  Loans ~ are the bank’s claims on its borrowers 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 that’s expressed as a “decimal”:  Reserve Ratio (R = 0.1) = 100 × Reserves/Deposits; such as, 100 × 1/10 = 100 × 0.1 = 10%  Money Multiplier (MM) = 1/R = 1/0.1 = 10; or if, R = 0.25 = 1/4 ~ MM = 1/R = 1/0.25 = 4  The higher (larger) the reserve ratio (R), the higher (greater) the amount of money that is kept in reserve, then the smaller the money multiplier becomes, then the less money that is loaned out (created) by the bank: ↑ R → ↓ 1/R (MM) → ↓ Loans Made → ↓ Money Supply o R = 0.05, then 0.05 ≤ R ≤ 1 and then 20 ≥ MM ≥ 1 ~ 0.05 = 1/20 and MM = 20 o R = 0.10, then 0.1 ≤ R ≤ 1 and then 10 ≥ MM ≥ 1 ~ 0.10 = 1/10 and MM = 10 o R = 0.25, then 1/R = 1/0.25 = 1/4; and then, MM = 4 which is the inverse of R  How $1,000 dollars are geometrically created from $100 via deposits and loans by the banks to increase the money supply in the economy: o Given that the MM = 10, then you have a reserve ratio (R = 1/10) of 10% and thusly 0.10 o ∑????=0 [100 × 1 ­ 0.10 )????]= $1,000 “geometrical summation series” o Created Money Supply = Total Money Supply ­ Original Deposit [$1000 ­ $100 = $900]  Increase (∆) in MS = Total MS ‐ Original Deposit [$40,000 - $2,000 = $38,000] In a 100% reserve banking system, banks do NOT affect the size of the money supply. Bank Capital ~ are the financial resources a bank’s owner or owners have put into its institution. This is also referred to as owner’s equity.  Owners’ Equity ~ also referred to as “bank capital” and is the owner’s personal resources used in the banking institution and business. (Owner’s Equity = Bank Assets ‐ Bank Liabilities) Leverage ~ is the use of borrowed money to supplement existing funds for investment purposes.  Margin accounts ~ are financial accounts in which money is borrowed against held securities as a form of buying leverage of stocks Leverage Ratio (LR) ~ is the ratio of total bank assets in terms of bank capital (or owner’s equity) ???????????????????? ???????????????? ???????????????????????? ???????????????????? ???????????????? ????????????????????????  Leverage Ratio = ′ and in reverse, Banker’s Capital = ???????????????????????? ???? ???????????????????????? ???????????????????????????????? ????????????????????  Leverage Ratio × Percentage Change in Assets = Percentage Change in Equity/Capital o When the leverage ratio is 20, a 5% increase in the value of assets increases the owner’s equity by 100% (20 × .05 = 1.00, then 1.00 × 100 = ↑ 100% ∆ in equity) o When the leverage ratio is 20, a 5% decrease in the value of assets decreases the owner’s equity by 100% (20 × ‐.05 = 1.00, then 1.00 × 100 = ↓ 100% ∆ in equity) Ouch!!! Realistic National Bank T-Account Assets Bank Liabilities & Owner’s Capital (Equity) Reserves $200 Deposits (Resources) $800 Loans $700 Debt $150 Securities $100 Owner’s Equity (Capital Resources) $50 Balance $1,000 Balance $1,000 Reserve Ratio (R) = 0.25 ~ 1/R = Money Multiplier (MM) = 4 ???????????????? ???? ???????????????????????????? ???????? ????????????????????1,000 Leverage Ratio (LR) = ???????????????????? ???? ???????????????????????? (????????????????????????????)50 = 20 Total of Bank Assets = Leverage Rate × Bank Equity = 20 × $50 = $1,000 1 1 ???????? = 20= 0.05 or 5% of the bank’s assets ($50) 950 50 [Each $1 of Bank Assets = $20 ] ~[ = $19 (bank liabilities) += $1 (bank equity)] 50 50 $800 + $150 = $950 and is the sum of the bank’s liabilities ~ $1,000 = is the bank’s total assets 5% increase in assets = $1,000 + $50 = $1,050 ~ $1,050 - $950 = $100 (owner’s capital doubled) 5% decrease in assets = $1,000 - $50 = $950 ~ $950 - $950 = $0 (owner has no equity left) 10% decrease in assets = $1,000 - $100 = $900 ~ $900 - $950 = –$50 (the bank is insolvent) Capital Requirement ~ is a government regulation specifying a minimum amount of bank capital. 1. This ensures that banks will be able to pay off their depositors without having to resort to government-provided deposit insurance funds. A “credit crunch” occurs when banks find themselves with too little capital to satisfy capital requirements and forces banks to reduce lending. Insolvent (insolvency) ~ occurs when a decrease in the bank’s assets is greater than the owner’s equity, meaning that its liabilities exceed its assets. 4 ~ THE FED’S TWO (2) TOOLS OF MONETARY CONTROL The “Fed’s” control of the money supply is indirect; however, it has 2 tools (groups or ways) by which to change and influence the money supply: 1. Influencing the quantity of reserves 2. Influencing the reserve ratio and money multiplier (1) Quantity of Reserves  Open-Market Operations (OMO) ~ the buying and selling of U.S. government bonds ~ this is the most often used by the federal reserve ~ buying bonds back to increase the money supply in the public and selling new bonds to gather currency out of the public’s hands o Each new dollar held as currency increases the money supply by exactly $1 dollar o Each new dollar deposited in a bank increases the money supply by more than $1 dollar because it increases reserves, and thereby, the amount of money that the banking system can create from the reserves. o To reduce the money supply, the government sells bonds to the public.  As people withdraw money from the banks to buy bonds and reducing the money in circulation (money stock), the bank’s reserves fall, and banks reduce lending because of the lower reserves and less money is loaned out.  When two people engage in transactions, the quantity of circulating money remains unchanged. o The money supply can be changed daily this way by small or large amounts by the “Fed” without major changes in laws or regulations:  ∆ In Money Supply = Money Multiplier × Reserves (Bonds) o If the reserve requirement (RR) is 10% (R = 0.1 and MM = 1/0.1 = 10) and the “Fed” sells one million dollars in government bonds, the economy’s reserves ↓ by 1 million, and the money supply ↓ $10 million. (∆ MS = MM × R, then MS = 10 × $1 = $10 million ↓) o The “Fed” wants to ↑ the money supply by $40 million and the reserve requirement is 20% and thusly the reserve ratio (R) = 0.2, and then the MM = (1/0.2) = 5. ∆ ???????? ???????????????????? ???????????????????????? $40 ????????????????????????????  Bonds (Reserves) = ???????????????????? ????????????????????????????????????????= 5 = $8 million repurchased bonds ∆ ???????? ???????????????????? ???????????????????????? ∆ ???????? ???????????????????? ???????????????????????? Or, Reserves (Bonds) = ???????????????????? ????????????????????????????????????????= 1/???? = ∆ In Money Supply × R which is: $40 million × 0.2 = $8 million dollars in repurchased bonds. Yahoo!!!  Fed Lending to Banks ~ the “Fed” can also increase the quantity of reserves in the economy by lending reserves to banks. o Banks can borrow from the “Fed’s” discount window and pay an interest rate called the discount rate. Banks borrow from the “Fed” if they don’t have enough reserves, to satisfy bank regulators, meet depositor withdrawals, and make new loans or any other business reason. o Discount Rate ~ is the interest on the loans that the “Fed” makes to banks. A higher discount rate discourages banks from borrowing from the “Fed,” and lower interest rates encourages banks to borrow from the “Fed.” o Term Auction Facility ~ is where the “Fed” sets up a quantity of funds to be loaned out and banks “bid” to borrow these funds. (2) The Reserve Ratio and Money Multiplier and how the Fed Influences the Reserve Ratio The “Fed” can influence the reserve ratio either through regulating the quantity of reserves banks must hold or through the interest rate the “Fed” pays banks on their reserves. Reserve Requirements (RR) ~ are regulations on the minimum amount of reserves that banks must hold against deposits. An increase in reserve requirements means that banks must hold more reserves; therefore, they loan out less of each dollar deposited.  An increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply: 0.2 ≤ R ≤ 1 and thusly ↓ money multiplier and ↓ money supply. o R = 0.1 ~ 1/0.1 = 10 and then R = 0.2 ~ 1/0.2 = 5  A decrease in reserve requirements lowers the reserve ratio, raises the money multiplier, and increases the money supply: 0.1 ≤ R ≤ 1 and thusly ↑ money multiplier ↑ money supply. o R = 0.2 ~ 1/0.2 = 5 and then R = 0.1 ~ 1/0.1 = 10 Paying Interest on Reserves ~ occurs when a bank holds reserves on deposit at the “Fed,” and the higher the interest rate paid by the “Fed,” the more reserves banks will choose to hold.  An increase in the interest rate on reserves tends to increase the reserve ratio, lowers the money multiplier and lowers the money supply: R = ???????????????????????????????? ???????????????????????? ???????????????????????????????? o ↑ interest rate ↑ reserve ratio and ↓ money multiplier and ↓ money supply o ↓ interest rate ↓ reserve ratio and ↑ money multiplier and ↑ money supply The “Fed’s” control of the money supply is not precise and has to wrestle with 2 problems: 1. They can’t control the amount of money that households choose to hold as deposits in banks: The less money households deposit, the less reserves banks have, and the less money the banking system can create. 2. The “Fed” does not control the amount of money that bankers choose to lend. When money is deposited in a bank, it creates more money only when banks lend it out, and the “Fed” isn’t sure how much money is being created by discretionary lending by banks.  Excess Reserve ~ is the amount of money in reserve that banks are holding above and beyond the minimum Federal Reserve requirement. Hence, in a system of fractional-reserve banking, the amount of money in the economy depends in part on the behavior of depositors and bankers.  The Federal Reserve does collect weekly data on deposits and reserves of banks and can compensate for household and bank behavior to retain fairly precise control over the money supply. Solvent (solvency) ~ refers to the assets which exceed the banks liabilities. Insolvent (insolvency) ~ refers to when the assets of a bank are less than its liabilities A run on banks ~ occurs when people suspect that their banks are in trouble, and they “run” to the bank to withdraw their funds, holding more currency and less deposits.  Under fractional-reserve banking, banks don’t have enough reserves to pay off all of the depositors, hence, banks may have to close.  Also, banks may make fewer loans and hold more reserves to satisfy depositors.  These events increase the reserve ratio (R), decrease loans offered and provided, reverses money creation and causes the money supply to fall. The Federal Funds Rate (FFR) Federal Funds Rate ~ is the short-term interest rate that banks charge one another for loans which are temporary and typically overnight: A bank with excess reserves will lend to a bank that is insufficient (short) on its financial reserve requirements for the day. This is an alternate way for banks to borrow in order to meet their reserve requirements and especially for the day.  The price of these inter-bank loans is set by supply and demand between banks  When the Fed buys bonds, money is injected into the banking system, banks then have less demand to borrow, and this decreases the Federal Funds Rate.  When the Fed sells bonds (money is pulled from the banking system), reserves decrease in the banking system, banks’ demand for reserves increases and the price of the Fed Funds Rate are bid up in price.  Open market operations (OMO) by the FOMC influence the “target” price of these loans o A decrease in the “target” price rate by buying bonds expands the money supply  Buy bonds → ↑ Reserves → ↑ Money Supply  Supply curve shifts to the right → ↓ the Fed Funds Rate (FFR) o An increase in the “target” price rate by selling bonds contracts the money supply  Sell bonds → ↓ Reserves → ↓ Money Supply  Supply curve shifts to the left → ↑ the Fed Funds Rate (FFR)  When the Fed Funds Rate ↑ or ↓, other interest rates usually move in the same direction which indicates the correlation, importance and impact this has on the economy. Problem ~ Just For Fun: If people hold equal amounts of currency (C) and demand deposits (D), and the money multiplier for reserves is 10, then two equations must be satisfied to determine the overall money supply: Assume that the reserve ratio is 10% and initial currency is $2,000:  C = D and is substituted into 10 × ($2,000 ­ C) = D  Which gives the equation: 10 × ($2,000 ‐ D) = D  $20,000 ‐ 10D = D  $20,000 = 11D and thusly D = $20,000 ÷ 11 = $1,818 for each of C and D  C + D = $3,636 is the total money supply  Created Money Supply = Total Money Supply ­ Original Deposit o $3,636 - $2.000 = $1,636 created money supply by bank loan(s)  Deposit + 0.9 Deposit = 1.9D ~ D = $1818/1.9 = $956.84 ~ Reserves = $95.68 ~ Loan = $861.16  Created Money = Value of the Loan × [(1 ‐ Reserve Ratio × Deposit) + (Deposi]) o Loan × (0.9 + 1) = 861.16 × 1.9 = $1,636 and also, $1,636/$861 = 1.9 CHAPTER 11 SUMMARY AND REVIEW OF QUICK NOTES The term money refers to assets that people regularly use to buy goods and services. Commodity money; such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money; such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money. In the U.S. economy, money takes the form of currency and various types of bank deposits; such as, checking accounts. Money serves 3 functions:  (1) As a medium of exchange, it is the item used to make transactions.  (2) As a unit of account, it provides the way in which prices and other economic values are recorded.  (3) As a store of value, it offers a way to transfer purchasing power from the present to the future. The Federal Reserve, the central bank of the United States, is responsible for regulating the U.S. monetary system. The Fed chairman is appointed by the president and confirmed by Congress every 4 years. The chairman is the head of the Federal Open Market Committee (FOMC), which meets about every 6 weeks to consider changes in monetary policy. Bank depositors provide resources to banks by depositing their funds into bank accounts. These deposits are part of a bank’s liabilities. Bank owners also provide resources (called bank capital) for the bank. Because of leverage (the use of borrowed funds for investment), a small change in the value of a bank’s assets can lead to a large change in the value of the bank’s capital. To protect depositors, bank regulators require banks to hold a certain minimum amount of capital. The “Fed” controls the money supply primarily through open-market operations: The purchase of government bonds increases the money supply, and the sale of government bonds decreases the money supply. The “Fed” also uses other tools to control the money supply. It can expand the money supply by decreasing the discount rate, increasing its lending to banks, lowering reserve requirements, or decreasing the interest rate on reserves. It can contract the money supply by increasing discount rate, decreasing its lending to banks, raising reserve requirements, or increasing the interest rate on reserves. When individuals deposit money in banks, and the banks loan out some of these deposits, the quantity of money in the economy increases. Because the banking system influences the money supply in this way, the “Fed’s” control of the money supply is imperfect. The “Fed” has in recent years set monetary policy by choosing a target for the federal funds rate, a short-term interest rate at which banks make loans to one another. As the “Fed” achieves its target, it adjusts the money supply. A medium of exchange is an item that buyers give to sellers when they purchase goods and services. A unit of account is the yardstick people use to post prices and record debts. A store of value is an item that people can use to transfer purchasing power from the present to the future. A U.S. penny is money in the U.S. economy because it is used as a medium of exchange to buy goods or services, it serves as a unit of account because prices in stores are listed in terms of dollars and cents, and it serves as a store of value for anyone who holds it over time. A Mexican peso is not money in the U.S. economy because it is not used as a medium of exchange in the United States, and it does not serve as a unit of account since prices are not given in terms of pesos. However, it does act as a store of value. A Picasso painting is not money because it does not act as a medium of exchange or a unit of account. It does, however, serve as a store of value. A plastic credit card is not money because it doesn’t have any of the three functions of money. Credit cards do not fully represent the medium of exchange function because they represent a deferred payment rather than an immediate payment, and not all stores accept credit cards. They also are not a unit of account or a store of value because they represent short-term loans rather than being an asset like currency. Banks can borrow funds from the Federal Reserve to make more loans when their own reserves approach the minimum amount allowed by the required reserve ratio. An increase in the discount rate makes borrowing from the Federal Reserve more expensive for banks. Because banks know that lending past the required reserve ratio will be more costly, they will be stingier with their lending, and fewer loans will be made. Fewer loans made means less money is created. A decrease in the discount rate has the opposite effect. Borrowing from the Federal Reserve becomes less expensive, so banks borrow more reserves from the Federal Reserve, increasing the level of reserves in the banking system. The injection of reserves allows banks to make more loans, creating additional money and increasing the money supply. To reduce the federal funds rate, the Federal Reserve uses open-market operations to buy government bonds from the public. The Federal Reserve's government bonds purchase injects reserves into the banking system. With additional reserves, banks are no longer as close to their required reserve ratio, so the demand from banks for borrowed reserves declines, pushing the federal funds rate downward. Similarly, the Federal Reserve sells government bonds in order to raise the federal funds rate. The sale of government bonds reduces the quantity of reserves in the banking system, causing banks' demand for borrowed reserves to rise. The increase in demand for borrowed reserves causes the federal funds to rise.


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