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25. The Money Supply and the Federal Reserve System. CHAPTER OUTLINE. An Overview of Money What Is Money? Commodity and Fiat Monies Measuring the Supply of Money in the United States The Private Banking System How Banks Create Money A Historical Perspective: Goldsmiths

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Chapter outline

25

The Money Supply and the Federal Reserve System

CHAPTER OUTLINE

An Overview of Money

What Is Money?

Commodity and Fiat Monies

Measuring the Supply of Money in the United States

The Private Banking System

How Banks Create Money

A Historical Perspective: Goldsmiths

The Modern Banking System

The Creation of Money

The Money Multiplier

The Federal Reserve System

Functions of the Federal Reserve

Expanded Fed Activities Beginning in 2008

The Federal Reserve Balance Sheet

How the Federal Reserve Controls the Money Supply

The Required Reserve Ratio

The Discount Rate

Open Market Operations

Excess Reserves and the Supply Curve for Money

Looking Ahead


Chapter outline

An Overview of Money

What Is Money?

Money is a means of payment, a store of value, and a unit of account.

A Means of Payment, or Medium of Exchange

barterThe direct exchange of goods and services for other goods and services.

medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services.


Chapter outline

An Overview of Money

What Is Money?

A Store of Value

store of valueAn asset that can be used to transport purchasing power from one time period to another.

liquidity property of moneyThe property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods.

A Unit of Account

unit of account A standard unit that provides a consistent way of quoting prices.


Chapter outline

An Overview of Money

Commodity and Fiat Monies

commodity moniesItems used as money that also have intrinsic value in some other use.

fiat, or token, moneyItems designated as money that are intrinsically worthless.

legal tenderMoney that a government has required to be accepted in settlement of debts.

currency debasementThe decrease in the value of money that occurs when its supply is increased rapidly.


Chapter outline

An Overview of Money

Measuring the Supply of Money in the United States

M1: Transactions Money

M1, or transactions moneyMoney that can be directly used for transactions.

M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits


Chapter outline

An Overview of Money

Measuring the Supply of Money in the United States

M2: Broad Money

near moniesClose substitutes for transactions money, such as savings accounts and money market accounts.

M2, or broad moneyM1 plus savings accounts, money market accounts, and other near monies.

M2 ≡ M1 + savings accounts + money market accounts + other near monies


Chapter outline

An Overview of Money

Measuring the Supply of Money in the United States

Beyond M2

There are no rules for deciding what is and is not money.

This poses problems for economists and those in charge of economic policy.


Chapter outline

An Overview of Money

The Private Banking System

financial intermediariesBanks and other institutions that act as a link between those who have money to lend and those who want to borrow money.

The main types of financial intermediaries are commercial banks, followed by savings and loan associations, life insurance companies, and pension funds.


Chapter outline

How Banks Create Money

A Historical Perspective: Goldsmiths

run on a bankOccurs when many of those who have claims on a bank (deposits) present them at the same time.

Today’s bankers differ from goldsmiths—today’s banks are subject to a “required reserve ratio.”

Goldsmiths had no legal reserve requirements, although the amount they loaned out was subject to the restriction imposed on them by their fear of running out of gold.


Chapter outline

How Banks Create Money

The Modern Banking System

A Brief Review of Accounting

Assets − Liabilities ≡ Net Worth

or

Assets ≡ Liabilities + Net Worth

Federal Reserve Bank (the Fed)The central bank of the United States.

reservesThe deposits that a bank has at the Central bank plus its cash on hand.

required reserve ratioThe percentage of its total deposits that a bank must keep as reserves at the Central Bank.


Chapter outline

How Banks Create Money

The Modern Banking System

A Brief Review of Accounting

 FIGURE 25.1 T-Account for a Typical Bank (millions of dollars)

The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).


Chapter outline

How Banks Create Money

The Creation of Money

excess reserves The difference between a bank’s actual reserves and its required reserves.

excess reserves ≡ actual reserves − required reserves

 FIGURE 25.2 Balance Sheets of a Bank in a Single-Bank Economy

In panel 2, there is an initial deposit of $100.

In panel 3, the bank has made loans of $400.


Chapter outline

How Banks Create Money

The Creation of Money

 FIGURE 25.3 The Creation of Money When There Are Many Banks

In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on.

In the end, loans of $400 have been made and the total level of deposits is $500.


Chapter outline

How Banks Create Money

The Money Multiplier

An increase in bank reserves leads to a greater than one-for-one increase in the money supply.

Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier.

money multiplierThe multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio.


Chapter outline

The Federal Reserve System

Functions of the Central Bank (CB)

From a macroeconomic point of view, the CB’s crucial role is to control the money supply.

The CB also performs several important functions for banks, such as clearing interbank payments, regulating the banking system, and assisting banks in a difficult financial position.

The CB is also responsible for managing exchange rates and the nation’s foreign exchange reserves.

It is often involved in intercountry negotiations on international economic issues.

lender of last resort One of the functions of the CB: It provides funds to troubled banks that cannot find any other sources of funds.


Chapter outline

The Federal Reserve System

The Federal Reserve Balance Sheet


Chapter outline

How the Central Bank Controls the Money Supply

  • If the CB wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves.

  • Three tools are available to the CB for changing the money supply:

  • Changing the required reserve ratio.

  • Changing the discount rate.

  • Engaging in open market operations.


Chapter outline

How the CB Controls the Money Supply

The Required Reserve Ratio


Chapter outline

How the Federal Reserve Controls the Money Supply

The Required Reserve Ratio

Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves.

As banks create more deposits by making loans, the supply of money (currency + deposits) increases.

The reverse is also true: If the CB wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans.

The result is a decrease in the money supply.


Chapter outline

How the Federal Reserve Controls the Money Supply

The Discount Rate

discount rateThe interest rate that banks pay to the CB to borrow from it.

moral suasionThe pressure that in the past the CB exerted on member banks to discourage them from borrowing heavily from the CB.


Chapter outline

How the Federal Reserve Controls the Money Supply

The Discount Rate


Chapter outline

How the Federal Reserve Controls the Money Supply

Open Market Operations

open market operationsThe purchase and sale by the CB of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

Two Branches of Government Deal in Government Securities

The Treasury Department is responsible for collecting taxes and paying the government’s bills.

The CB is not the Treasury. It is a quasi-independent agency authorized to buy and sell outstanding (preexisting) Turkish. government securities on the open market.


Chapter outline

How the Federal Reserve Controls the Money Supply

Open Market Operations

The Mechanics of Open Market Operations


Chapter outline

How the Federal Reserve Controls the Money Supply

Open Market Operations

The Mechanics of Open Market Operations

We can sum up the effect of these open market operations this way:

■An open market purchase of securities by the CB results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

■An open market sale of securities by the CB results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.


Chapter outline

How the Federal Reserve Controls the Money Supply

Excess Reserves and the Supply Curve for Money

 FIGURE 25.5 The Supply of Money

If the CB’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line.

Through its three tools, the CB is assumed to have the money supply be whatever value it wants.


Chapter outline

Looking Ahead

This chapter has discussed only the supply side of the money market.

In the next chapter, we turn to the demand side of the money market.

We will examine the demand for money and see how the supply of and demand for money determine the equilibrium interest rate.


Chapter outline

moral suasion

near monies

Open Market Desk

open market operations

required reserve ratio

reserves

run on a bank

store of value

unit of account

1. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

2. M2 ≡ M1 + savings accounts + money market accounts + other near monies

3. Assets ≡ Liabilities + Net Worth

4. Excess reserves ≡ actual reserves − required reserves

5. Money multiplier ≡

R E V I E W T E R M S A N D C O N C E P T S

barter

commodity monies

currency debasement

discount rate

excess reserves

Federal Open Market Committee (FOMC)

Federal Reserve Bank (the Fed)

fiat, or token, money

financial intermediaries

legal tender

lender of last resort

liquidity property of money

M1, or transactions money

M2, or broad money

medium of exchange, or means of payment

money multiplier


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