Chapter 17: Money and the Federal Reserve

After Great Depression → FDIC - deposit insurance now guarantees that depositors will get their deposits back up to $______ even if bank goes bankrupt.

$250,000

Why are banks very important to the economy?

- (1) Critical participants in market for loanable funds → provide a way for savers to supply their funds to borrowers without purchasing a financial security - (2) Play a role in money supply process - Deposits → Primary source of funds → BANKS → loans → primary use of funds - banks are the middlemen of this process - Banks can be profitable if they charge a higher interest rate on loans they make than interest rate they pay out on deposits - Fund activities primarily by taking in deposits

Fed sells and buys securities because...

- Goal is to get those funds directly into market for loanable funds → financial institutions can lend new money and it quickly moves into economy - Typical day's worth of open market operations could entail billions - can't do that with actual goods and services without messing up market

3 functions of money

- a medium of exchange - a unit of account - a store of value

Simple Money Multiplier

1/rr, rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves - In end, impact of deposits on money supply is a large multiple of the increase in money - depends on required reserve ratio - In reality, people hold some money and there are excess reserves, therefore simple mm is the MAXIMUM size of the money multiplier - Fed can change the money multiplier by changing the required reserve ratio - if it is lowered, money multiplier increases, and if it raised the multiplier falls - Lower reserve, bank can give more loans (larger portion of deposits) - Since small changes in money multiplier can lead to large swings in money supply, changing reserve requirement can cause the money supply to change too much - Also changing it can be unpredictable because banks actions are

What is the ideal relationship between assets and liabilities?

Assets > liabilities - positive owner's equity - right side is source of funds

Why does money deposited into the banking system lead to more money?

Because depositing allows the bank to use it even more than you would.

Why does loaning deposits create more money?

Because money can essentially be used twice.

Why are credit cards *not* part of the money supply?

Because they are a source of *borrowed* funds, the funds are already in existence but just circulated → third party paying for purchase until loan repaid

What is the difference between two interest rates (reserve v. loan)?

Cost of decision

Discount Rate

Interest rate on the discount loans made from Fed to private banks - set since loan is directly from branch of US gov't to private financial institutions - Fed has used discount rate to administer monetary policy - Used to decrease it to discourage borrowing and decrease money supply / increase it to encourage borrowing and increase money supply but now not used because not seen as helpful

Balance Sheet

accounting statement that summarizes a firm's key financial information

Relationship between the Federal Reserve and commercial banks is _______ to the relationship between commercial banks and households/firms

analogous - Households and firms deposit at banks → banks hold deposits at Fed - federal funds - Households and firms take out loans from banks → banks take out loans from the Fed

Required Reserve Ratio

banks are legally bound to hold a portion of deposits on reserve: *Required reserves = rr * deposits*

As long as dollars find their way back into banking system...

banks multiple them into more deposits → more money

Type A banks

conservative, take little risk and earn little returns on loans 0 make only safe loans with low default risk and give low rates of return, but rarely fail

As a byproduct of everyday activity, banks create new money - not by minting currency but by...

creating new deposits - part of money supply

Checkable Deposits

deposits in bank accounts from which depositors may make withdrawals by writing checks - Represent purchasing power that is very similar to currency

Federal Funds

deposits that private banks hold on reserve at the Fed - Part of the reserves that banks set aside along with physical currency in their vaults - Banks keep reserves at the Fed in part because the Fed clears loans between them and other banks - when banks loan reserves to other banks, they are federal funds loans - Enable banks to make quick adjustments to balance sheets

Regarding jobs of the Federal Reserve, specifically bank regulation: The fed is one of the primary entities charged with...

ensuring the financial stability of banks, including determination of reserve requirements

M2

everything in M1 + savings deposits, includes money market mutual funds and small-denomination time deposits - key is that money supply in an economy includes currency and bank deposits: *Money supply (m) = currency + deposits*

Type B banks

greater default risk but higher returns - often fail

Although private individuals and firms are not permitted to print currency, private actions absolutely influence the total supply of money in the economy because...

individuals and banks affect deposits (commercial banks not investment)

Federal Funds Rate

interest rate on interbank loans

When Fed wants to increase money supply...

it buys financial securities - Fed buys bonds from financial institutions with new dollars

When Fed wishes to decrease the money supply...

it sells financial securities - Exchanges bonds with financial institutions for existing dollars

Assets

left side of balance sheet, items that firm owns - indicate how the banking firm uses funds it has raised from various sources

Banks either _______ or _______.

lend money; put it into reserves

Discount Loans

loans from the Fed to private banks - vehicle by which the Fed performs its role as a "lender of last resort" - Fed is a backup lender to private banks that find difficulty borrowing elsewhere

Store of Value

means of holding wealth - but importance in modern times has declined because money can be put into banks and earned interest on

Unit of Account

measure in which prices are quoted - like speaking a common language, universally accepted unit - Also allows for accurate comparisons between items b/c represents value - measuring stick and recording device

M1

money supply measure that is composed of currency and checkable deposits - Obsolete after the ATM → made checkings and savings very similar - now M2 is a better indicator because of this

Commodity-backed Money

money that can be exchanged for a commodity at a fixed rate - advantage is that it ties value of holders' money to something real - Limits what can be printed, limits inflation - Disadvantage: tying value of nation's currency to a commodity is dangerous when the market value of that commodity fluctuates → changes in price of this creates inflation because purchasing power changes - risky

Fiat Money

money that has no value except as the medium of exchange - no inherent or intrinsic value to the currency - paper has value because government has mandated that we can use the currency to pay debts - Disadvantage: no limit on how much can be produced → inflation

Regarding jobs of the Federal Reserve, specifically bank regulation: The fed monitors balance sheets of banks to limit risks and needs to because of...

moral hazard problem & problems because of interdependence in banking

Bank Run

occurs when many depositors attempt to withdraw their funds at the same time, could occur if customers find out bank would have difficulty meeting withdrawal requests → why we need a reserve - Banks can never let depositors withdraw all at the same time → will fail, but on a normal day only small # of people actually withdraw - if word comes out that bank is unstable → bank run, bank failures i.e. Great Depression

Currency

paper bills and coins that are used to buy goods and services

Reserves

portion of bank deposits that are set aside and not lent out - Include currency in bank's vault and funds that the bank holds in deposit at its own bank, the Federal Reserve - also hold Treasury securities - Banks hold reserves because they must accommodate withdrawals → need to be accountable for the money they hold - Also legally bound

Open Market Operations

purchase or sale of bonds by a central bank

Regarding jobs of the Federal Reserve, specifically monetary policy: The fed controls US money supply and is charged with...

regulating it to offset macroeconomic fluctuations

Banks loan out most of deposits because...

reserves earn very little interest - every dollar on reserve costs the bank potential income

Liabilities

right side of balance sheet, financial obligations firm owes

Equity

right side, difference between assets and liabilities

Currency is money, but only constitutes a _____ part of the total money supply.

small - people use alternatives and we need to find a way to measure the total value of all of these alternatives

Quantitative Easing

targeted use of open market operations in which the central bank buys securities specifically targeted in certain markets - long-term too - Action leads to lower interest rates in that market - new since 2008 - Implemented because Fed had already pushed short-term rates down to zero - traditional market operations had reached a boundary - Introduced during slow recovery from Great Recession for troubled markets

Quantity of money in the economy affects...

the ease with which individuals and firms can make purchases and also affects the price level

Regarding jobs of the Federal Reserve, specifically central banking: The fed serves as bank for banks, and holds...

their deposits and extending loans to them - crucial to the support and stability of entire banking system

Excess Reserves

total reserves - required reserves - banks rarely keep exactly required amount, but more

Barter

trading goods and services for goods and services - no medium of exchange, money's alternative - Barter requires a double coincidence of wants - each party in an exchange has to have what the other party desires → pretty unusual → medium of exchange naturally evolves because everyone wants $$$

Commodity Money

use of an actual good in place of money (gold) - Often difficult to carry, transportation costs → money in certificates that represented a fixed quantity of the commodity - still could be traded for commodity if buyer demanded it

Medium of exchange

what people trade for goods and services

Moral Hazzard

when a party that is protected from risk behaves differently from the way it would behave if it were fully exposed to the risk - FDIC created this - meant that banks and deposits had no incentive to monitor risk because they are protected from the consequences no matter Moral hazard → type B banks because tremendous upside and no significant downside since depositors are protected by FDIC insurance BUT recessions often start in financial industry

Fractional Reserve Banking

when banks only hold a fraction of deposits on reserve, our modern system of banking - Alternative: 100% reserve banking, no loans, essentially just safes - Allows access to funds by many individuals and firms in an economy, but can also lead to instability when many depositors demand their funds simultaneously