Chapter 17: Economics

M2

A broader measure of the money supply which includes everything in M1 plus savings deposits -Also includes two other types of deposits: money market mutual funds and small-denomination time deposits (certificates of deposit, or CDs)

Store of Value

A means for holding wealth Money has long served as an important store of value -But in modern economies, this function is much less important because today, we have other options for holding our wealth -We can easily put our dollars into bank accounts or investment accounts that earn interest (caused money's role as a store of value to decline -One of the three functions of money

Balance Sheet

An accounting statement that summarizes a firm's key financial information -A financial statement that reports assets, liabilities, and owner's equity on a specific date -Information about a bank's financial operations is available in the bank's balance sheet -The left side of the balance sheet details the bank's assets and the right side of the balance sheet details the bank's liabilities and owner's equity along with net worth -The third item on the right side of the balance sheet is net worth, or the owner's equity in the bank

Excess Reserves

Any bank reserves held in excess of those required -Banks rarely keep their level of reserves exactly at the required level

Money

Any generally accepted means of payment -Money has three functions: it is a medium of exchange, a unit of account, and a store of value

Why Banks Hold Reserves

-Banks hold reserves for two reasons -First, they must accommodate withdrawals by their depositors If word spread that a bank might have difficulty meeting its depositors' withdrawal requests, that news would probably lead to a bank run -Second, banks are legally bound to hold a fraction of their deposits on reserve -Currently, the required reserve ratio is 10% for almost all deposits (rr = 0.10) -This means your bank can legally lend out up to 90 cents of every dollar you deposit

Banks Loaning Reserves to Other Banks

-Banks keep reserves at the Fed in part because the Fed clears loans between banks -When banks loan reserves to other banks, these are federal funds loans -Typically very short term (often overnight), and they enable banks to make quick adjustments to their balance sheets -For example, if our theoretical University Bank somehow dips below its required reserve level, it can approach Township Bank for a short-term loan. If Township Bank happens to have excess reserves, making a short-term loan enables it to earn interest

Fiat Money

Money with no value except as the medium of exchange; there is no inherent or intrinsic value to the currency -In the United States, our currency is physically just pieces of green paper, otherwise known as Federal Reserve Notes

Commodity-Backed Money

Money you can exchange for a commodity at a fixed rate -For example, until 1971, U.S. dollars were fixed in value to specific quantities of silver and gold -While commodity money and commodity-backed money evolve privately in all economies, the type of money used in most modern economies depends on government

Fractional Reserve Banking

Occurs when banks hold only a fraction of deposits on reserve (our modern system of banking) -The alternative is 100% reserve banking where banks don't loan out deposits; these banks are essentially just safes, keeping deposits on hand until depositors decide to make a withdrawal

Double Coincidence of Wants

Occurs when each party in an exchange transaction happens to have what the other party desires -Pretty unusual, which is why a medium of exchange naturally evolves in any exchange environment

Bank Run

Occurs when many depositors attempt to withdraw their funds from a bank at the same time

Reserves

The portion of bank deposits set aside and not loaned out -A second important asset held by banks is reserves -Include both currency in the bank's vault and funds that the bank holds in deposit at its own bank, the Federal Reserve

Role of Banks in The Macroeconomy

-Banks serve two very important roles in the macroeconomy -First, they are critical participants in the market for loanable funds -Provide a way for savers to supply their funds to borrowers without purchasing a financial security and play a role in determining the money supply -Banks are financial intermediaries; that is, they take in deposits and extend loans -Deposits are the primary source of funds, and loans are the primary use of these funds -Banks can be profitable if the interest rate they charge on loans is higher than the interest rate they pay out on deposits -The interest rates on bank deposits and bank loans for U.S. banks go up and down together, but the interest rate on deposits is consistently lower than the interest rate on loans -The difference between the two interest rates pays a bank's operating costs and produces profits

The Fed

-The Fed was established in 1913 as the central bank of the United States wit the primary responsibilities being: -Monetary policy: The Fed controls the U.S. money supply and is charged with regulating it to offset macroeconomic fluctuations -Central banking: The Fed serves as a bank for banks, holding their deposits and extending loans to them -Bank regulation: The Fed is one of the primary entities charged with ensuring the financial stability of banks, including the determination of reserve requirements -The Fed is a "central bank"—that is, it acts as a "bank for banks" Offers support and stability to the nation's entire banking system

Money Supply (M) Equation

-The key point to remember is that the money supply in an economy includes both currency and bank deposits: -Actual data for both M1 and M2 are regularly published by the Federal Reserve -Because credit card purchases involve the use of borrowed funds, credit cards are not included as part of the money supply

Simply Money vs Realistic Money Multiplier

-There is a more realistic money multiplier that relaxes the two assumptions -Consider how a real-world money multiplier would compare with the simple money multiplier: -First, if people hold on to some currency (relaxing assumption 1), banks cannot multiply that currency, so the more realistic multiplier is smaller than the simple money multiplier -Second, if banks hold excess reserves (relaxing assumption 2), these dollars are not multiplied, and again the real multiplier is smaller than the simple version

Commodity-Backed vs Fiat Money

-Commodity-backed money ties the value of the holder's money to something real -If the government is obligated to trade silver for every dollar in circulation, a limit is imposed on the number of dollars it can print, which probably limits inflation levels (pro of commodity-backed money) -Fiat money offers no such constraint on the expansion of the money supply, possibly leading to rapid monetary expansion and then inflation -On the other hand, tying the value of a nation's currency to a commodity is dangerous when the market value of the commodity fluctuates (con of commodity-backed money) -An increased supply of gold (from a new discovery) reduces gold prices, and therefore more gold is required in exchange for all other goods and services (leading to inflation) -Because a change in the value of a medium of exchange affects the prices of all goods and services in the macroeconomy, it can be risky to tie a currency to a commodity

Required Reserve Ratio Example

-For this example, we need to make two assumptions to help understand the general picture: All currency is deposited in banks and banks hold no excess reserves -With a required reserve ratio of 10% (rr = 0.10), University Bank loans out $900 of your deposit (assumption 2 implies that only 10% of deposits are held on reserve) -When University Bank extends the loan to Kaitlyn, the money supply increases by $900 -That is, you still have your $1,000 deposit, and Kaitlyn now has $900 -Township Bank also keeps no excess reserves, so it loans out 90% of the $900, which is $810 (from when Kaitlyn deposits the $900 here) -This loan creates $810 more in money supply, so total new money is now $1,000 + $900 + $810 = $1,710

How Banks Create Money Example

-If you keep the newly created $1,000 in your wallet, then the money supply increases by only $1,000 -But if you deposit the new money in a bank, then the bank can use it to create even more money -When you deposit the $1,000, it is still part of the money supply, because both currency and bank deposits are counted in the money supply -Therefore, the deposit still represents $1,000 worth of the medium of exchange -But University Bank doesn't keep your $1,000 in reserve; it uses part of your deposit to extend a new loan that earns interest income for the bank -Thus, University Bank creates new money by loaning out part of your deposit

Reserve Requirements and Discount Rates

-In the past, the Fed made use of two other tools in its administration of monetary policy: reserve requirements and the discount rate -Haven't been used recently for monetary policy, but they are available and historically important -If the Fed lowers the required reserve ratio, the money multiplier increases (and vice-versa) -Lowering the required reserve would mean that banks could loan out a larger portion of their deposits, enabling them to create money by multiplying deposits to a greater extent than before

Fractional Reserve Banking System Explained

-In this system, deposits come into the banks, and the banks send out a portion of these funds in loans -In recent years, U.S. banks have typically loaned out almost 90% of their deposits, keeping barely over 10% on reserve -Banks loan out most of their deposits because reserves earn very little interest; every dollar kept on reserve costs the bank potential income -If the bank rejects the firm's loan application and decides to keep the funds in its vault as reserves, the cost of this decision to the bank is the difference between these two interest rates: 5% - 0.25% = 4.75%

Components of Bank Assets

-Loans -Reserves -Banks also hold U.S. Treasury securities and other government securities as substantial assets in their portfolio -These securities earn interest and carry very low risk -Finally, banks hold other assets, such as physical buildings and furnitur

Roles of The Fed

-Offers support and stability to the nation's entire banking system -The Fed also serves as a regulator of individual banks by doing the setting and monitoring of reserve requirements -The Fed monitors the balance sheets of banks with an eye toward limiting the riskiness of the assets the banks hold -This is done because the interdependent nature of banking firms means that banking problems often spread throughout the entire industry very quickly -In addition, there is the moral hazard problem because of deposit insurance and banks/customers have reduced incentives to monitor the risk of bank assets on their own

Why the Fed Buys/Sells Treasury Securities

-The Fed buys and sells Treasury securities for two reasons -First, the Fed's goal is to get the funds directly into the market for loanable funds -In this way, financial institutions begin lending the new money, and it quickly moves into the economy -Second, a typical day's worth of open market operations might entail as much as $20 billion in purchases -The market for U.S. Treasuries is big enough to accommodate this level of purchases seamlessly as the daily volume in the U.S. Treasury market is over $500 billion

Why Reserve Requirements and Discount Rates are Not Used Anymore

-This tool is not as precise or predictable as open market operations are -Because small changes in the money multiplier can lead to large swings in the money supply, changing the reserve requirement can cause the money supply to change too much -In addition, changing reserve requirements can have unpredictable outcomes because the overall effects depend on the actions of banks -For these reasons, the reserve requirement has not been used for monetary policy since 1992 -The Fed has also used the discount rate to administer monetary policy -In the past, the Fed would (1) increase the discount rate to discourage borrowing by banks and to decrease the money supply or (2) decrease the discount rate to encourage borrowing by banks and to increase the money supply -The Fed used this tool actively until the Great Depression era, but is no longer viewed as a helpful tool for changing the money supply

Why Using M1 Became Less Relevant

-Until the 1970s, M1 was the most closely monitored money supply measure because it was a reliable estimate of the medium of exchange -But the introduction of automated teller machines (ATMs) rendered M1 obsolete as a reliable money supply measure -Depositors can make withdrawals at any time and at many locations and debit cards are an even easier way to access your bank deposits -Because both checking and savings accounts are now readily available for purchasing goods and services, M2—which includes both types of deposits—is now a better measure of our economy's medium of exchange

Checkable Deposits

Deposits in bank accounts from which depositors may make withdrawals by writing checks -Represent purchasing power very similar to currency, because personal checks are accepted at many places -Adding checkable deposits to currency gives us a money supply measure known as M1

Federal Funds

Deposits that private banks hold on reserve at the Fed -The word "federal" seems to denote that these are government funds, but in fact they are private funds held on deposit at a federal agency—the Fed -These deposits are part of the reserves that banks set aside, along with the physical currency in their vaults

Open Market Operations

Involve the purchase or sale of bonds by a central bank -When the Fed wants to increase the money supply, it buys securities; in contrast, when it wishes to decrease the money supply, it sells securities -The U.S. Treasury security are the securities (bonds) that the Fed typically buys and sells when implementing monetary policy -The Fed undertakes open market operations every business day, which are also the primary tool that the Fed uses to expand or contract the money supply in order to affect the macroeconomy -One of the main tools the Fed uses when it wants to alter the supply of money

Barter

Involves the trade of a good or service in the absence of a commonly accepted medium of exchange -Involves individuals trading some good or service they already have for something else they want -Barter requires a double coincidence of wants

Commodity Money

Involves the use of an actual good for money -Historically, the first medium of exchange in an economy has been a commodity that is actually traded for goods and services -The good itself has value apart from its function as money (gold, silver, and the tobacco of colonial Virginia) -Due to commodities being difficult to carry around, money evolved into certificates that represented a fixed quantity of the commodity -Certificates became the medium of exchange but were still tied to the commodity, because they could be traded for the actual commodity if the holder demanded it

Owner's Equity

The difference between the firm's assets and its liabilities -When a firm has more assets than liabilities, it has positive owner's equity -Overall, the right side of the balance sheet identifies the bank's sources of funds -One of the three main components of a balance sheet

Liabilities

The financial obligations the firm owes to other -One of the three main components of a balance sheet

Discount Rate

The interest rate on the discount loans made from the Fed to private banks -The Fed sets this interest rate because it is a loan directly from a branch of the U.S. government to private financial institutions

Federal Funds Rate

The interest rate that banks charge each other on interbank loans -The relationship between the Federal Reserve and commercial banks is analogous to the relationship between commercial banks and households and firms -First, households and firms hold deposits at banks, and banks hold deposits at the Fed—these are the federal funds -Second, households and firms take out loans from banks, and banks take out loans from the Fed

Assets

The items the firm owns -Indicate how the banking firm uses the funds it has raised from various sources -One of the three main components of a balance sheet

Moral Hazard

The lack of incentive to guard against risk where one is protected from its consequences -Neither banks nor their depositors have an incentive to monitor risk; no matter what happens, they are protected from the consequences of risky behavior -Moral hazard draws individual depositors and bankers to type B banking (huge risks to make huge profits) -There is a tremendous upside and no significant downside, because depositors are protected against losses by FDIC insurance (modern state of banking)

Discount Loans

The loans from the Fed to the private banks -The vehicle by which the Fed performs its role as "lender of last resort" -Given the macroeconomic danger of bank failure, the Fed serves an important role as a backup lender to private banks that find difficulty borrowing elsewhere -In extremely turbulent times, they reassure financial market participants (like for the struggling banks in 2008

Unit of Account

The measure in which prices are quoted -Money enables you and someone you don't know to speak a common language -Using money as a unit of account is so helpful that a standard unit of account generally evolves, even in small economies -Expressing the value of something in terms of dollars and cents also enables people to make accurate comparisons between items (like a measuring stick and recording device) -You use dollar amounts to keep track of your account and to record transactions in a consistent manner -One of the three functions of money

M1

The money supply measure composed of currency and checkable deposits -Also includes traveler's checks, but these account for a very small portion of M1

Currency

The paper bills and coins used to buy goods and services

Required Reserve Ratio (rr)

The portion of deposits that banks are required to keep on reserve -For a given bank, the dollar amount of reserves it is required to hold is determined by multiplying the required reserve ratio by the bank's total amount of deposits: -Currently, the required reserve ratio is 10% for almost all deposits (rr = 0.10) -This means your bank can legally lend out up to 90 cents of every dollar you deposit

Simple Money Multiplier (m^m)

The rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves -In the end, the impact on the money supply is a large multiple of the initial increase in money -The simple money multiplier represents the maximum size of the money multiplier -The money multiplier process also works in reverse

Quantitative Easing

The targeted use of open market operations in which the central bank buys securities specifically targeting certain markets -Together with an additional $175 billion in purchases of securities from government-sponsored enterprises, the Fed's purchases amounted to almost $2 trillion in new funds injected into the economy --In summary, quantitative easing was a new variation of open market operations introduced during the slow recovery from the Great Recession -Traditional open market operations had reached a boundary and the Fed searched for other actions

Medium of Exchange

What people trade for goods and services -Modern economies generally have a government-provided medium of exchange (the US government provides our currency) -Even in economies without government provision, a preferred medium of exchange usually emerges -Invariably, some medium of exchange evolves in any economy; the primary reason is the inefficiency of barter, which is money's alternative -One of the three functions of money