Econ 104: Money, Banks, And The Federal Reserve System

What is the Troubled Asset Relief Program (TARP)?

The Fed and Treasury began attempting to stabilize the commercial banking system by providing funds to banks in exchange for stock. -Taking partial ownership of private commercial banks was an unprecedented move by the federal government. -The Fed also modified its discount policy by setting up several new lending facilities. These lending facilities made it possible for the Fed to grant discount loans to financial firms that had not previously been eligible.

How do you avoid the problems of barter?

Societies have an incentive to identify a product that most people will accept in exchange for what they have to trade. -Commodity Money-A good used as money that also has value independent of its use as money. -Historically, once a good became widely accepted as money, even people who did not have an immediate use for it would be willing to accept it.

Why was the Federal Reserve put in place?

-Bank panics lead to severe disruptions in business activity because households and firms have trouble accessing their accounts and may be unable to borrow money. -In the United States, each bank panic in the late nineteenth and early twentieth centuries was accompanied by a recession. -With the intention of putting an end to bank panics, in 1913, Congress passed the Federal Reserve Act, which set up the Federal Reserve System. -Congress divided the country into 12 Federal Reserve Districts. Each district has its own Federal Reserve Bank, which provides services to banks in that district.

Why does the Fed conducts monetary policy principally through open market operations?

-Because the Fed initiates open market operations, it completely controls their volume, which means the Fed can carry out both large and small open market operations. -Open market operations are easily reversible. For example, if the Fed believes that previous open market purchases have caused the money supply to increase too rapidly, it can engage in open market sales. -The Fed can implement its open market operations quickly, with no administrative delay or required changes in regulations.

How does the Fed use discount policy and reserve requirements to manage money supply?

-By lowering the discount rate, the Fed can encourage banks to take additional loans and thereby increase their reserves. -When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves. -The Fed rarely changes reserve requirements because doing so can disrupt banks' operations by forcing them to significantly change their holdings of loans, bonds, and other securities. -The Fed pays banks only a low interest rate on reserves, raising the required ratio effectively places a tax on banks' reserve holdings.

What about credit cards and debit cards?

-Credit cards are not included in either definition of the money supply. -The reason is that when you buy something with a credit card, you are in effect taking out a loan from the bank that issued the credit card. -With a debit card, the funds to make the purchase are taken directly from your checking account.

How do we know that your initial $1,000 deposit ultimately leads to a total increase in deposits of $10,000?

-Each bank in the money supply process is keeping reserves equal to 10 percent of its deposits. -The system as a whole will end up with $10,000 in deposits because $1,000 is 10 percent of $10,000. -Simple deposit multiplier=1/required reserve ratio -The larger the required reserve ratio, the smaller the simple deposit multiplier.

What are the functions of money?

-It must act as a medium of exchange. -It must serve as a unit of account. -It must serve as a store of value. -It must provide a standard of deferred payment.

What other shadow banking systems take place?

-Money market mutual funds sell shares to investors and use the money to buy short-term securities such as Treasury bills and commercial paper issued by corporations. -Mortgage-backed securities proved very popular with investors because they often paid higher interest rates than other securities that seemed to have comparable default risk. -Hedge funds raise money from wealthy investors and use sophisticated investment strategies that often involve significant risk. -By the mid-2000s, hedge funds had become an important source of demand for securitized loans and an important source of loans to other financial firms.

Why doesn't simple deposit multiplier work in real life?

-Since the financial crisis that began in 2007, banks have kept substantial excess reserves. -We would expect to see people increasing the amount of currency they hold as the balances in their checking accounts rise. -The effect of these two simplifications is to reduce the real-world deposit multiplier to about 1.6 during normal times. So, a $1 increase in the reserves of the banking system typically results in about a $1.60 increase in deposits. -Following the financial crisis of 2007-2009, the surge in bank holdings of excess reserves reduced the multiplier to less than 1.

Why would the Fed be hesitant to loan banks experiencing bank runs?

-The Fed's first test as a lender of last resort came in the early years of the Great Depression of the 1930s. -Fed officials declined to make loans to many banks because the officials were worried that banks experiencing runs had made bad loans and other investments. -The Fed believed that making loans to banks that were in financial trouble because of bad investments might reduce the incentive bank managers had to be careful in their investment decisions.

What can serve as money?

-The asset must be acceptable to (that is, usable by) most people. -It should be of standardized quality so that any two units are identical. -It should be durable so that value is not lost by its quickly wearing out. -It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported. -It should be divisible so that it can be used in purchases of both low-priced and high-priced goods.

What is the shadow banking system?

-The financial system was transformed in the 1990s and 2000s by the increasing importance of nonbank financial firms. -Investment banks, such as Morgan Stanley, differ from commercial banks in that they do not accept deposits, and they rarely lend directly to households. -Investment banks traditionally concentrated on providing advice to firms issuing stocks and bonds or considering mergers with other firms. -Mortgage-Backed Securities-Investment banks expanded their buying of mortgages, bundling large numbers of them together and reselling them to investors.

Why did the financial crisis of 2007 happen?

-The government agencies—including the Federal Reserve—that regulated the commercial banking system did not regulate the shadow banking system. -These firms were more highly leveraged—that is, they relied more heavily on borrowed money to finance their operations—than were commercial banks. -Beginning in 2007, some firms in the shadow banking system experienced runs because they are not insured by the federal deposit insurance. -As housing prices began to fall, a significant number of borrowers defaulted on their mortgages, which caused mortgage-backed securities to lose value. -The resulting credit crunch (decline in lending activity by financial institutions brought on by a sudden shortage of funds) significantly worsened the recession that had begun in December 2007.

What are the Board of Governors?

-The real power of the Fed lies in Washington, DC, with the Board of Governors. -The seven members of the Board of Governors are appointed by the president of the United States to 14-year, nonrenewable terms. -One member of the Board of Governors is appointed chair and serves a 4-year, renewable term.

What else is included in M2?

-Time deposits with a value of less than $100,000, primarily certificates of deposits in banks (These deposits are for a fixed period of time—usually from six months to several years—and withdrawals before that time are subject to a penalty).. -Noninstitutional money market mutual fund shares. -Noninstitutional means that individual investors rather than institutional investors, such as pension funds, own the money market fund shares.

How do reserves affect money supply?

-When banks gain reserves, they make new loans, and the money supply expands. -When banks lose reserves, they reduce their loans, and the money supply contracts.

What is a lender of last resort?

A central bank, like the Federal Reserve in the United States, can help stop a bank panic by making loans to banks that cannot borrow funds elsewhere. -The banks can use these loans to pay off depositors. When the panic ends and the depositors put their money back in their accounts, the banks can repay the loans to the central bank.

What is on a bank's balance?

A firm's assets are listed on the left, and its liabilities and stockholders' equity are listed on the right. -Stockholders' equity is the difference between the total value of assets and the total value of liabilities. -Stockholders' equity represents the value of the firm if it were closed, all its assets were sold, and all its liabilities were paid off. -A corporation's stockholders' equity is also called its net worth. -A bank's stockholders' equity or net worth is also called its capital. -The key assets on a bank's balance sheet are its reserves, loans, and holdings of securities, such as U.S. Treasury bills.

What is a T-account?

A stripped-down version of a balance sheet that shows only how a transaction changes a bank's balance sheet. -Any transaction that increases (or decreases) one side of the balance sheet must also increase (or decrease) the other side of the balance sheet. -The total value of all the entries on the right side of a balance sheet must always be equal to the total value of all the entries on the left side of a balance sheet. -Banks are required to keep 10 percent of deposits as reserves. Because the Federal Reserve pays banks only a low rate of interest on their reserves, banks have an incentive to loan out or buy securities with the other 90 percent.

What is a fractional reserve banking system?

Banks keep less than 100 percent of deposits as reserves. -When people deposit money in a bank, the bank loans most of the money to someone else. -If a small amount more is withdrawn than deposited, banks can cover the difference from their excess reserves or by borrowing from other banks. -Bank Run-When many depositors simultaneously decide to withdraw their money from a bank. -Bank Panic-If many banks experience runs at the same time. -Contagion-Depositors demand funds from other banks. -It is possible for one bank to handle a run by borrowing from other banks, but if many banks simultaneously experience runs, the banking system may be in trouble.

What types of loans do banks make?

Banks make consumer loans to households and commercial loans to firms. -Loans are assets to banks. -A bank's reserves and its holdings of securities are also assets because they are things of value the bank owns. -Deposits are a typical bank's largest liability. -Banks also borrow short term from other banks and from the Federal Reserve and borrow long term by selling bonds to investors.

Why do we need money?

By making exchange easier, money allows people to specialize, become more productive, and earn higher incomes. -When money is available, families are more likely to specialize and less likely to produce everything or nearly everything they need themselves. -People become much more productive by specializing because they can pursue their comparative advantage.

How can we calculate the total increase in checking account deposits from an increase in bank reserves?

Change in bank reserves *(1/required reserve ratio)

What is securitizing?

Creates a secondary market in which loans that have been bundled together can be bought and sold in financial markets, just as corporate or government bonds are. -Banks have begun to resell many of their loans rather than keep them until borrowers pay them off. -Financial firms other than commercial banks have become important sources of credit to businesses. -Security-A financial asset (stock or bond) that can be bought and sold in a financial market. -Primary Market-When a financial asset is first sold. -Secondary Market-If an investor resells the asset.

What are reserves?

Deposits that a bank has retained rather than loaned out or invested. -Required Reserves-Banks are required by law to keep as reserves 10 percent of their checking account deposits above a threshold level, which in 2017 was $115.1 million. -Required Reserve Ratio-The minimum fraction of deposits that banks are required to keep as reserves. -Excess Reserves-Any reserves that banks hold above the legal requirement

What are barter economies?

Economies in which goods and services are traded directly for other goods and services. -For a barter trade to take place between two people, each person must want what the other one has. Economists refer to this requirement as a double coincidence of wants. -It may take several trades before the farmer is ultimately able to trade for what the neighbor with the cow wants. Locating several trading partners and making several intermediate trades can take considerable time and energy.

Who holds these dollars outside the United States?

Foreign banks and foreign governments hold some U.S. currency, but most is held by households and firms in countries in which there is not much confidence in the local currency or in which the underground economy is large. -When inflation rates are very high, many households and firms do not want to hold their domestic currency because it is losing its value too rapidly. -The value of the U.S. dollar will be much more stable than their domestic currency. If enough people are willing to accept dollars as well as—or instead of—domestic currency, dollars become a second currency for the country. -In 2008, when inflation soared in the African country of Zimbabwe to the point where it took 15 billion Zimbabwean dollars to buy a can of Coca-Cola, the government went so far as to adopt the U.S. dollar as the country's official currency.

What is the key to acceptance?

Households and firms have confidence that if they accept paper dollars in exchange for goods and services, the dollars will not lose much value during the time they hold them.

What is the Federal Deposit Insurance Corporation (FDIC)?

Insures deposits in most banks up to a limit, which is currently $250,000 per deposit, per bank. -If the bank where you have your checking account goes out of business, the FDIC will refund your money after a wait of at most two days. -Deposit insurance has greatly reduced bank runs because it has reassured all but the largest depositors that their deposits are safe

Why does U.S. dollar bill have the words "Federal Reserve Note"?

It is issued by the Federal Reserve. -U.S. dollars are fiat money, so the Federal Reserve is not required to give you gold or silver for your dollar bills. -Federal Reserve currency is legal tender in the United States, which means the federal government requires that it be accepted in payment of debts and requires that cash or checks denominated in dollars be used in payment of taxes.

What is M2?

M2 includes everything that is in M1 plus savings account deposits. -Almost all currency, checking account deposits, and traveler's checks were held with the intention of buying and selling, not with the intention of storing value. -Before 1980, U.S. law prohibited banks from paying interest on checking account deposits. Households and firms held checking account deposits primarily to buy goods and services. -This change reduced the difference between checking accounts and savings accounts, although people are still not allowed to write checks against their savings account balances.

What is fiat money?

No value except as money. -Paper currency has no value unless it is used as money, and it is therefore not a commodity money. -It can be inefficient for an economy to rely only on gold or other precious metals for its money supply. -Beginning around the year 1500 in Europe, governments and private firms, early banks, began to store gold and issue paper certificates that could be redeemed for gold. -In modern economies, paper currency is generally issued by a central bank, which is an agency of the government that regulates the money supply (Federal Reserve).

Why are people interested in the money supply?

People are interested in the money supply because, as we will see, changes in the money supply can affect other economic variables, including employment, gross domestic product (GDP), and inflation. -If the only function of money was to serve as a medium of exchange, then a narrow definition of the money supply should include only currency, checking account deposits, and traveler's checks because households and firms can easily use these assets to buy goods and services.

What is the Federal Open Market Committee (FOMC)?

The Federal Reserve committee responsible for open market operations and managing the money supply in the U.S. -The committee has 12 voting members. -The 7 members of the Federal Reserve's Board of Governors. -The president of the Federal Reserve Bank of New York. -The presidents of 4 of the other 11 Federal Reserve Banks.

Why do people hold any money?

The answer has to do with liquidity, or the ease with which people can convert an asset into the medium of exchange. -Ex-If you want to buy a car and need to sell bonds or stocks to do so, you will have to pay a commission. -To avoid such costs, people are willing to hold some of their wealth in the form of money, even though other assets offer greater returns as stores of value.

What is M1?

The narrow definition of the money supply. -Currency, which is all the paper money and coins held by households and firms (not including currency held by banks). -The value of all checking account deposits in banks. -The value of traveler's checks.

What is simple deposit multiplier?

The ratio of the amount of deposits created by banks to the amount of new reserves. -Your initial deposit of $1,000 increased the reserves of the banking system by $1,000 and led to a total increase in checking account deposits of $10,000. -In this case, the simple deposit multiplier is equal to $10,000/$1,000 = 10.

What is the Fed's authority?

The system began operation in 1914, with the authority to make loans to banks. -Discount Loans-The loans the Fed makes to banks. -Discount Rate-The interest rate it charges on the loans. -When a bank receives a loan from the Fed, its reserves increase by the amount of the loan.

What is the total amount of money in circulation?

The total amount of currency in circulation—$1.5 trillion in June 2017. -This amount is more than $4,500 per person—adult or child—in the United States. If this sounds like an unrealistically large amount of currency to be held per person, it is. -Economists estimate that more than 60 percent of U.S. currency is actually outside the borders of the United States.

How important is it that money be a reliable store of value and standard of deferred payment?

The value of money depends on its purchasing power, which is its ability to buy goods and services. -When inflation reaches very high levels, money is no longer a reliable store of value or standard of deferred payment.

Could an economy function without money?

There are historical examples of economies in which people traded goods for other goods rather than use money. -Ex-On the American frontier during colonial times, very little money was available, so a farmer might have traded a plow for a cow. -Money-Any asset that people are generally willing to accept in exchange for goods and services or for payment of debts. -Asset-Anything of value owned by a person or a firm.

How does the Fed manage the money supply?

They use monetary policy for open market operations, discount policy, and reserve requirements. -All three of the Fed's policy tools are aimed at affecting the reserves of banks as a means of changing the volume of checking account deposits. -Many other central banks, including the European Central Bank and the Bank of Japan, also use open market operations to conduct monetary policy. -The Federal Reserve is responsible for putting the paper currency of the United States into circulation (The currency is actually printed by the U.S. Treasury).

What are open market operations?

To control the size of the money supply, the Fed buys and sells Treasury securities. -To increase the money supply, the FOMC directs the trading desk, located at the Federal Reserve Bank of New York, to carry out an open market purchase by buying U.S. Treasury securities. -The Fed pays for the Treasury bills by depositing the funds in the reserve accounts that banks maintain with the Fed. -To decrease the money supply, the FOMC directs the trading desk to carry out an open market sale by selling Treasury securities. -This decrease in reserves starts a contraction of loans and checking account deposits that reduces the money supply.