The Money System: Powerpoint Slides Prepared By: Andreea Chiritescu Eastern Illinois University

The Money System
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 1
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The Meaning of Money
• Money
– Set of assets in an economy
– That people regularly use
– To buy goods and services from other
people
• The functions of money
– Medium of exchange
– Unit of account
– Store of value
• Medium of exchange
– Item that buyers give to sellers
• When they want to purchase goods and
services
• Unit of account
– Yardstick people use to post prices and
record debts
• Store of value
– Item that people can use to transfer
purchasing power
• From the present to the future
• Liquidity
– Ease with which an asset can be
converted into the economy’s medium of
exchange
The Kinds of Money
• Commodity money
– Money that takes the form of a commodity
with intrinsic value
• Intrinsic value
– Item would have value even if it were not
used as money
• Gold standard - Gold as money
– Or paper money that is convertible into
gold on demand
The Kinds of Money
• Fiat money
– Money without intrinsic value
– Used as money because of government
decree
• Fiat
– Order or decree
Money in the U.S. Economy
• Money stock
– Quantity of money circulating in the
economy
• Currency
– Paper bills and coins in the hands of the
public
• Demand deposits
– Balances in bank accounts - depositors
can access on demand by writing a check
Money in the U.S. Economy
• Measures of money stock
– M1
• Demand deposits, Traveler’s checks
• Other checkable deposits, Currency
– M2
• Everything in M1
• Savings deposits, Small time deposits
• Money market mutual funds
• A few minor categories
Figure 1
Two Measures of the Money Stock for the U.S. Economy
The two most widely followed measures of the money stock are M1 and M2. This
figure shows the size of each measure in 2009.
Where is all the currency?
• 2009: $862 billion currency outstanding
– Average adult: holds about $3,653 of
currency
– Much of the currency is held abroad
– Much of the currency is held by drug
dealers, tax evaders, and other criminals
• Currency – not a particularly good way to
hold wealth
– Can be lost or stolen
– Doesn’t earn interest
Banks and the Money Supply
• Reserves
– Deposits that banks have received but
have not loaned out
• The simple case of 100% reserve banking
– All deposits are held as reserves
• Banks do not influence the supply of money
Fractional-Reserve Banking
• Fractional-reserve banking
– Banks hold only a fraction of deposits as
reserves
• Reserve ratio
– Fraction of deposits that banks hold as
reserves
• Reserve requirement
– Minimum amount of reserves that banks
must hold; set by the Fed
• Excess reserve
– Banks may hold reserves above the legal
minimum
• Example: First National Bank
– Reserve ratio 10%
• Banks hold only a fraction of deposits in
reserve
– Banks create money
• Assets
• Liabilities
– Increase in money supply
– Does not create wealth
The Money Multiplier
• The money multiplier
– Original deposit = $100.00
– First National lending = $ 90.00 [= .9 ×
$100.00]
– Second National lending = $ 81.00 [= .9 ×
$90.00]
– Third National lending = $ 72.90 [= .9 ×
$81.00]
–…
– Total money supply = $1,000.00
• The money multiplier
– Amount of money the banking system
generates with each dollar of reserves
– Reciprocal of the reserve ratio = 1/R
• The higher the reserve ratio
– The smaller the money multiplier
Financial Crisis of 2008–2009
• If bank’s assets – rise in value by 5%
– Because some of the securities the bank
was holding rose in price
– $1,000 of assets would now be worth
$1,050
– Bank capital rises from $50 to $100
– So, for a leverage rate of 20
• A 5% increase in the value of assets
• Increases the owners’ equity by 100%
Fed’s Tools of Monetary Control
• Influences the quantity of reserves
– Open-market operations
– Fed lending to banks
• Influences the reserve ratio
– Reserve requirements
– Paying interest on reserves
• Open-market operations
– Purchase and sale of U.S. government
bonds by the Fed
– To increase the money supply
• The Fed buys U.S. government bonds
– To reduce the money supply
• The Fed sells U.S. government bonds
– Used more often
• Fed lending to banks
• To increase the money supply
• Discount window
• At the discount rate
– Term Auction Facility
• To the highest bidder
• The discount rate
– Interest rate on the loans that the Fed
makes to banks
– Higher discount rate
• Reduce the money supply
– Smaller discount rate
• Increase the money supply
• Term Auction Facility
– The Fed sets a quantity of funds it wants
to lend to banks
– Eligible banks bid to borrow those funds
– Loans go to the highest eligible bidders
• Acceptable collateral
• Pay the highest interest rate
• Reserve requirements
– Regulations on minimum amount of
reserves
• That banks must hold against deposits
– An increase in reserve requirement
• Decrease the money supply
– A decrease in reserve requirement
• Increase the money supply
– Used rarely – disrupt business of banking
• Paying interest on reserves
– Since October 2008
– The higher the interest rate on reserves
• The more reserves banks will choose to hold
– An increase in the interest rate on
reserves
• Increase the reserve ratio
• Lower the money multiplier
• Lower the money supply
Bank runs and the money supply
• Bank runs
– Depositors suspect that a bank may go
bankrupt
• “Run” to the bank to withdraw their deposits
– Problem for banks under fractional-
reserve banking
• Cannot satisfy withdrawal requests from all
depositors
• When a bank run occurs
– The bank - is forced to close its doors
– Until some bank loans are repaid
– Or until some lender of last resort
provides it with the currency it needs to
satisfy depositors
– Complicate the control of the money
supply
• Great Depression, early 1930s
– Wave of bank runs and bank closings
– Households and bankers - more cautious
– Households
• Withdrew their deposits from banks
– Bankers - responded to falling reserves
• Reducing bank loans,
• Increased their reserve ratios
• Smaller money multiplier
• Decrease in money supply
• Bank runs today
– Not a major problem
• The federal government
– Guarantees the safety of deposits at
most banks
• Federal Deposit Insurance Corporation
(FDIC)
• No bank runs
– Depositors are confident
– FDIC will make good on the deposits
• Government deposit insurance
– Cost:
• Bankers - little incentive to avoid bad risks
– Benefit:
• A more stable banking system
The Federal Funds Rate
• The federal funds rate
– Interest rate at which banks make
overnight loans to one another
• Lender – has excess reserves
• Borrower – needs reserves
– A change in federal funds rate
• Changes other interest rates
The Federal Funds Rate
• Fed: target the federal funds rate
– Open-market operations
• The Fed buys
– Decrease in the federal funds rate
– Increase in money supply
• The Fed sells
– Increase in the federal funds rate
– Decrease in money supply

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