Money and the Banking System

1. Money and the Banking System

2. Do you know anyone with a lot of money? What does that mean? Some people make a great income each year. So they probably have a lot of money. Some people are born into families with a lot of wealth – Bill Gates’ kids are an example. They, too, probably have a lot of money. Here we want to focus on those things that we call money. But we do not focus on the income or wealth aspects. We want to see how policy dealing with money can affect the operation of the economy.

3. Overview Here we want to study the monetary system in the US. Monetary policy is a tool designed to get the interest rate to a level so that investment can be at a desired level. Policy makers ultimately want to have economic growth, price stability and full employment. Reaching these goals can be influenced by Federal Reserve policy. Let’s begin our study of this material by asking what is money?

4. What is money? You might say money is the dollars we have, and that is right , but more basically anything that performs the functions of money is money. The three functions of money are 1) medium of exchange, 2) Unit of account, and 3) Store of value. A medium of exchange means money is the thing that is readily accepted as payment for goods and services. When money is used we don’t have to barter. Barter can be a drag because of the double coincidence of wants.

5. What is money? As a unit of account, the monetary unit(what we call the dollar) is how we state relative value. Goods and services have prices stated in terms of the monetary unit. We know the relative worth of stuff by looking at the dollar amount of the stuff. Money is a store of value, meaning that you can use it now, or you can use it later. Other assets also act as a store of value, but money has the advantage of immediate use by a firm or a household in meeting all financial obligations.

6. Commodity money and fiat money section Commodity money is when money takes the form of something with intrinsic value. Money would have value for uses other than just money. Cigarettes in a prison would be commodity money. I think fiat money is the money tucked into the glove compartment on that little car.  Really, fiat money has no intrinsic value. Government says something is money and it is. Our dollars are fiat money.

7. M1 definition of money In the US, the most basic definition of money is M1 = coins + paper + checkable deposits + other checkable deposits + travelers’ checks, or more basically for our purpose = currency + checkable deposits. Checks are dollar denominated accounts at banks and other financial institutions. They are money because they are generally accepted as a medium of exchange. Caution: 1) Credit cards are NOT money, they are loans for our purposes.

8. What ‘backs’ our money? A gold standard or other metal standard - meaning there can be only as much money as there is gold, or some formula amount of money per ounce of gold - may not be consistent with our desires to make trades. This is why modern economies have moved away from metal standards. So, what backs our money? Our money is backed by our faith that it can be readily used. We accept money because we know others will accept it from us!!

9. The Federal Reserve The Federal Reserve, hereafter called the Fed, is the central bank in the US. The Fed was established in 1913, has 12 districts, is run by a seven member Board of Governors appointed by the president, and is owned by member banks. The functions of the Fed are to 1) supply the economy with fiduciary currency 2) provide a system of check collection and clearing 3) hold depository institutions’ reserves 4) act as the governments fiscal agent 5) supervise member banks 6) act as the “lender of last resort” 7) regulate the money supply. Let’s look at each of these on the following screens.

10. Fed functions 1) The paper currency is printed by the Bureau of Engraving but is controlled by the Fed. The currency is a Federal Reserve note - check a bill you have. 2) Check collection and clearing. Say you buy something from LL Bean and write a check and send it to Boston. The Boston bank that gets the check from LL Bean can check with the Fed and see the bank you wrote the check on. Your account then is subtracted from and LL Bean’s account is added to. 3) The Fed is often called a bankers bank and as such bankers keep some of their reserves at the Fed. When you put money in the bank, the bank has a liability since it is responsible to you. It also now has an asset that is called reserves.

11. fed functions 4) As the government’s fiscal agent the Fed acts as the bank for the US Treasury. Government revenues go to the Fed and checks to pay for stuff comes from the Fed. 5) The Fed supervises member banks to make sure they are not doing “dumb” stuff. The Fed can make unannounced visits to check the bank out. 6) The Fed is a lender of last resort. If a financial institution has troubles the Fed can lend it the funds it needs to stay in business. This happens from time to time. 7) The Fed regulates or controls the money supply through monetary policy.

12. FOMC FOMC The Federal Open Market Committee (FOMC) is really the part of the Fed that controls the money supply. They decide when to buy or sell bonds in the market to influence the amount of money in the system.