ECON 102: Chapter 16 - The Monetary System.

M1:

-Currency. -Demand deposits. -Traveler's checks. -Other checkable deposits.

M2:

-Savings deposits. -Small time deposits. -Money market mutual funds. -A few minor categories. -M2 has more assets than M1.

What is a depository institution?

A bank that accepts deposits but does not make loans.

What does an increase in reserve requirements mean?

An increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply. -When the Fed increases reserve requirements, some banks find themselves short of reserves, even though they have seen no change in deposits. -The higher the interest rate on reserves, the more reserves banks will choose to hold. -An increase in the interest rate on reserves will tend to increase the reserve ratio, lower the money multiplier, and lower the money supply.

How can the Fed increase the quantity of reserves in the economy?

By lending reserves to banks. -When the Fed makes such a loan to a bank, the banking system has more reserves than it otherwise would, and these additional reserves allow the banking system to create more money. -Reserve requirements influence how much money the banking system can create with each dollar of reserves.

Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount.

If banks hold all deposits in reserve, banks do not influence the supply of money.

What is leverage?

Leverage is the use of borrowed money to supplement existing funds for investment purposes.

What is Money?

Money is the set of assets in the economy that people regularly use to buy goods and services from each other. -A share of stock is NOT considered a form of money.

What is the key point to take away regarding the money stock for the U.S. economy?

The money stock for the U.S. economy includes not only currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services. -The account balances that lie behind debit cards are included in measures of the quantity of money.

What is bank capital?

The resources that a bank obtains from issuing equity to its owners.

What is the purpose of a capital requirement?

To ensure that banks will be able to pay off their depositors, without having to resort to government-provided deposit insurance funds.

Federal Open Market Committee:

-Made up of the 7 members of the board of governors and five of the twelve regional bank presidents. -5 of the 12 regional presidents get to vote. New York's president always gets a vote. -Through the decisions of the FOMC, the Fed has the power to increase or decrease the number of dollars in the economy. -Primary tool of the Fed is the OPEN-MARKET OPERATION; the purchase and sale of U.S. government bonds.

What are the three functions of money in the economy?

1. Medium of exchange: An item that buyers give to sellers when they purchase goods and services. 2. Unit of account: The yardstick people use to post prices and record debts. -If you take out a loan from a bank, the size of your future loan repayments will be measured in dollars, not in a quantity of goods and services. 3. Store of value: An item that people can use to transfer purchasing power from the present to the future. -When a seller accepts money today in exchange for a good or service, that seller can hold the money and become a buyer of another good or service at another time. -Holding stocks and bonds is another store of value. It is also a form of WEALTH.

The Fed can alter the money supply by changing the discount rate.

A higher discount rate discourages banks from borrowing reserves from the Fed. -An increase in the discount rate reduces the quantity of reserves in the banking system, which in turn reduces the money supply. -At the discount window, the Fed sets the price of a loan and the banks determine the quantity of borrowing.

Fractional-reserve banking:

Banks have to keep some reserves so that currency is available if depositors want to make withdrawals. Can loan out money to earn interest. -The fraction of total deposits that a bank holds as reserves is called the RESERVE ratio (influenced by both government regulation and bank policy). -Because banks create money in a system of fractional-reserve banking, the Fed's control of the money supply is indirect.

What are demand deposits?

Demand deposits are balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a store. -Demand deposits are included in the money stock. -Additionally, depositors in money market mutual funds can often write checks against their balances (included).

What are reserves?

Deposits that banks have received but have not loaned out.

What happens if the FOMC decides to increase the money supply?

If the FOMC decides to increase the money supply, the Fed creates dollars and uses them to buy government bonds from the public in the nation's bond markets. -An open-market purchase of bonds by the Fed increases the money supply. -If the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation's bond markets. -An open-market sale of bonds by the Fed decreases the money supply. -Prices rise when the government prints too much money. -Fed policy also influences the economy's employment and production on the short run.

What is fiat money?

Money without intrinsic value. -The acceptance of fiat money depends as much on expectations and social convention as on government decree.

Federal Reserve:

Regulates the system of fiat money. -The Fed is a CENTRAL BANK - an institution designed to oversee the banking system and regulate the quantity of money in the economy. -The Fed is run by the board of governors, which has 7 members appointed by the president and confirmed by the Senate (14-year terms). -Fed governors are given long terms to give them independence from short-term political pressures when they formulate monetary policy. Chair is the most important role (4-year term appointed by the president). -The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and 12 regional Federal Reserve Banks located in major cities around the country. The presidents of the regional banks are chosen by each bank's board of directors. -The Fed has 2 jobs: the first is to regulate banks and ensure the health of the banking system.

Open-market operations:

The Fed conducts open-market operations when it buys or sells government bonds. To increase the money supply, buy bonds from the public. -Each new dollar deposited in a bank increases the money supply by more than a dollar because it increases reserves and, thereby, the amount of money that the banking system can create. -The Fed can change the money supply by a small or large amount on any day without major changes in law or bank regulations.

What does the Fed do?

The Fed monitors each bank's financial condition and facilitates bank transactions by clearing checks. -The Fed also makes loans to banks when banks want to borrow. -The Fed acts as a "lender of last resort" - a lender to those who cannot borrow anywhere else. -The Fed also is in charge of controlling the quantity of money that is made available in the economy, called the MONEY SUPPLY. -Monetary policy is made by the FOMC.

What is a reserve requirement?

The Fed sets a minimum amount of reserves that banks must hold. -Banks may hold reserves above the legal minimum, called EXCESS RESERVES, so they can be more confident that they will not run short of cash. -The money supply increases when a bank lends out some of the deposits. -The money supply can equal currency + demand deposits. -When banks hold only a fraction of deposits in reserve, the banking system creates money. -When a bank loans out some of its reserves and creates money, it does not create any wealth. -Each time that money is deposited and a bank loan is made, more money is created.

What is the leverage ratio equal to?

The LEVERAGE RATIO = the ratio of the bank's total assets to bank capital.

What is the money multiplier?

The amount of money the banking system generates with each dollar of reserves is called the money multiplier. -THE MONEY MULTIPLIER IS THE RECIPROCAL OF THE RESERVE RATIO. -"If the banking system as a whole holds a total of 'x' in reserves, it can have only 'x' in deposits." The ratio of deposits to reserves. -If the reserve ratio = 1/20, then the banking system would have 20 times as much in deposits as in reserves. Each dollar of reserves would generate $20 of money.

How does a bank decide how to allocate its resources?

The bank decides how to allocate its resources among asset classes based on their risk and return, as well as on any regulations (such as reserve requirements) that restrict the bank's choices.

What is liquidity?

The ease with which an asset can be converted into the economy's medium of exchange.

What does a higher reserve ratio mean?

The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier.

What does intrinsic value mean?

The item would have value even if it were not used as money. -Gold is an example of commodity money.