The Monetary System Lecture 5 17.3.2015 Copyright © 2004 South-Western Outline • The role of money in economy • What is money • Banking system • How can government control the quantity of money in circulation • Inflation • Long-run effects of changes in the quantity of money Copyright © 2004 South-Western THE MEANING OF MONEY • Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Copyright © 2004 South-Western The Functions of Money • Money has three functions in the economy: • Medium of exchange • Unit of account • Store of value Copyright © 2004 South-Western The Functions of Money • Medium of Exchange • A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. • A medium of exchange is anything that is readily acceptable as payment. Copyright © 2004 South-Western The Functions of Money • Unit of Account • A unit of account is the yardstick people use to post prices and record debts. • Store of Value • A store of value is an item that people can use to transfer purchasing power from the present to the future. Copyright © 2004 South-Western The Functions of Money • Liquidity • Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange. Copyright © 2004 South-Western The Kinds of Money • Commodity money takes the form of a commodity with intrinsic value. • Examples: Gold, silver, cigarettes. • Fiat money is used as money because of government decree. • It does not have intrinsic value. • Examples: Coins, currency, check deposits. Copyright © 2004 South-Western Money in the U.S. Economy • Currency is the paper bills and coins in the hands of the public. • Demand deposits are balances in bank accounts that depositors can access on demand by writing a check. Figure 1 Money in the U.S. Economy (2009) Copyright©2003 Southwestern/Thomson Learning Billions of Dollars • Currency ($580 billion) • Demand deposits • Traveler’s checks • Other checkable deposits ($599 billion) • Everything in M1 ($1,179 billion) • Savings deposits • Small time deposits • Money market mutual funds •A few minor categories ($4,276 billion) 0 M1 $1,179 M2 $5,455 Copyright © 2004 South-Western BANKING SYSTEM • Commercial banks - accept deposits and issue loans • 100% reserve banking • Fractional-reserve banking – can issue loans – create money • Central bank • It is designed to oversee the banking system. • It regulates the quantity of money in the economy. • The Federal Reserve (Fed) serves as the nation’s central bank. Copyright © 2004 South-Western Central Banks • Three Primary Functions of the central banks • Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices (sets minimal reserves). • Acts as a banker’s bank, making loans to banks and as a lender of last resort. • Conducts monetary policy by controlling the money supply. Monetary policy is the setting of the money supply by policymakers in the central bank (Open market operations ). Copyright © 2004 South-Western Money supply • Open-Market Operations • The money supply is the quantity of money available in the economy. • The primary way in which the Fed changes the money supply is through open-market operations. • The Fed purchases and sells U.S. government bonds. • To increase the money supply, the Fed buys government bonds from the public. • To decrease the money supply, the Fed sells government bonds to the public. Copyright © 2004 South-Western BANKS AND THE MONEY SUPPLY • Banks can influence the quantity of demand deposits in the economy and the money supply. Copyright © 2004 South-Western BANKS AND THE MONEY SUPPLY • Reserves are deposits that banks have received but have not loaned out. • In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. • Reserve Ratio • The reserve ratio is the fraction of deposits that banks hold as reserves. Copyright © 2004 South-Western Money Creation with Fractional-Reserve Banking • The money supply is affected by the amount deposited in banks and the amount that banks loan. • Deposits into a bank are recorded as both assets and liabilities. • The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. • Loans become an asset to the bank. Copyright © 2004 South-Western Money Creation with Fractional-Reserve Banking • This T-Account shows a bank that… • accepts deposits, • keeps a portion as reserves, • and lends out the rest. • It assumes a reserve ratio of 10%. Assets Liabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 Copyright © 2004 South-Western The Money Multiplier Assets Liabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 Assets Liabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00 Money Supply = $190.00! Copyright © 2004 South-Western The Money Multiplier • How much money is eventually created in this economy? • The money multiplier is the amount of money the banking system generates with each dollar of reserves. Copyright © 2004 South-Western The Money Multiplier • The money multiplier is the reciprocal of the reserve ratio: M = 1/R • With a reserve requirement, R = 20% or 1/5, • The multiplier is 5. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • The Fed has three tools in its monetary toolbox: • Open-market operations • Changing the reserve requirement • Changing the discount rate Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Open-Market Operations • The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: • When the Fed buys government bonds, the money supply increases. • The money supply decreases when the Fed sells government bonds. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Changing the Discount Rate • The discount rate is the interest rate the Fed charges banks for loans. • Increasing the discount rate decreases the money supply. • Decreasing the discount rate increases the money supply. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Reserve Requirements • The Fed also influences the money supply with reserve requirements. • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. Copyright © 2004 South-Western The Fed’s Tools of Monetary Control • Changing the Reserve Requirement • The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. • Increasing the reserve requirement decreases the money supply. • Decreasing the reserve requirement increases the money supply. Copyright © 2004 South-Western Problems in Controlling the Money Supply • The Fed’s control of the money supply is not precise. • The Fed must wrestle with two problems that arise due to fractional-reserve banking. • The Fed does not control the amount of money that households choose to hold as deposits in banks. • The Fed does not control the amount of money that bankers choose to lend. Copyright © 2004 South-Western Summary • The term money refers to assets that people regularly use to buy goods and services. • Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value. • Commodity money is money that has intrinsic value. • Fiat money is money without intrinsic value. Copyright © 2004 South-Western Summary • The Federal Reserve, the central bank of the United States, regulates the U.S. monetary system. • It controls the money supply through openmarket operations or by changing reserve requirements or the discount rate. Copyright © 2004 South-Western Summary • When banks loan out their deposits, they increase the quantity of money in the economy. • Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.