Chapter 4: The Monetary System: what it is and how it works

Financial crisis

A major disruption in the financial system that impedes the economy's ability to intermediate between those who want to save and those who want to borrow and invest.

Capital requirement

A minimum amount of bank capital mandated by regulators

Fractional-reserve banking

A system in which banks keep only some of their deposits on reserve. (Cf. 100-percent-reserve banking.)

Balance sheet

An accounting statement that shows assets and liabilities

Medium of exchange

An item widely accepted in transactions for goods and services; one of the functions of money. (Cf. store of value, unit of account.)

Bitcoins are an example of:

As a form of money, bitcoins are neither commodity money nor fiat money. Unlike commodity money, they have no intrinsic value. You can't use bitcoins for anything other than exchange. Unlike fiat money, they are not created by government decree.

Demand deposits

Assets that are held in banks and can be used on demand to make transactions, such as checking accounts.

monetary base (B)

B=C+R

Measures of Money Supply

C=Currency M1=Currency plus demand deposits, traveler's checks, and other checkable deposits M2=M1 plus retail money market mutual fund balances, saving deposits (including money market deposit accounts), and small time deposits

Financial intermediaries

Institutions that facilitate the matching of savers and borrowers, such as banks

money

Is the stock of assets that can be readily used to make transactions

Money Supply=Currency+ Demand Deposits (M=C+D)

M= Money Supply C= Currency in Circulation D= Demand Deposits

money supply (M)

M= Money multiplier (m) x monetary base (B) or M= (cr+1)/(cr+rr) x B

money supply (M)

M=C+D

Types of Money

commodity money (gold), representative, fiat money

The currency-deposit ratio cr

is the amount of currency C people hold as a fraction of their holdings of demand deposits D. It reflects the preferences of households about the form of money they wish to hold.

The reserve-deposit ratio rr

is the fraction of deposits that banks hold in reserve. It is determined by the business policies of banks and the laws regulating banks.

Monetary base B

is the total number of dollars held by the public as currency C and by the banks as reserves R. It is directly controlled by the Federal Reserve.

Ex: Suppose that the monetary base B is $800 billion, the reserve-deposit ratio rr is 0.1, and the currency-deposit ratio cr is 0.8. In this case, the money multiplier is

m=(0.8+1)/(0.8+0.1)=2.0 where B=$800 rr=0.1 cr=0.8 M=2.0 x $800=$1,600 billion In conclusion: each dollar of the monetary base generates two dollars of money, so the total money supply is $1,600 billion

commodity money

objects that have value in themselves as well as for use as money such as gold

How the Fed Changes the Monetary Base

open-market operations are the purchases and sales of government bonds by the Fed.

quantitative easing (QE)

the purchase of long term government and private mortgage-backed securities by central banks to make credit available in hopes of stimulating aggregate demand

The Instruments of Monetary Policy

those that influence the monetary base and those that influence the reserve-deposit ratio and thereby the money multiplier.

Money multiplier (m)

(cr+1)/(cr+rr) Cr= currency-deposit ratio rr= reserve-deposit ratio

Central bank

The institution responsible for the conduct of monetary policy, such as the Federal Reserve in the United States

Discount rate

The interest rate that the Fed charges when it makes loans to banks.

The money supply: the model has three exogenous variables

1) The monetary base (B) 2) The reserve-deposit ratio (rr) 3) The currency-deposit ratio (cr)

Gold standard

A monetary system in which gold serves as money or in which all money is convertible into gold at a fixed rate.

100-percent-reserve banking

A system in which banks keep all deposits on reserve. (Cf. fractional reserve banking.)

Store of value

A way of transferring purchasing power from the present to the future; one of the functions of money. (Cf. medium of exchange, unit of account.)

Unit of account

The measure in which prices and other accounting records are recorded; one of the functions of money. (Cf. medium of exchange, store of value.)

Financial markets

Markets through which savers can directly provide resources to borrowers, such as the stock market and bond market.

medium of exchange

Money is what people use to buy goods and services."this note is legal tender for debts, public and private" is printed on the U.S dollar. When you walk into stores, you are confident that shopkeepers will accept your money in exchange for the items they are selling. The ease with which an asset can be converted into the medium of exchange and used to buy other things(goods,services, or capital assets) is called the asset's liquidity. Because money is the medium of exchange it is the economy's most liquid asset.

unit of account

Money provides the terms in which people quote prices and record debts (a car cost $40.000 or number of debts)

Commodity money

Money that is intrinsically useful and would be valued even if it did not serve as money. (Cf. fiat money, money.)

fiat money

Money that is not intrinsically useful and is valued only because it is used as money. (Cf. commodity money, money.)

Reserve requirements

Regulations imposed on banks by the central bank that specify a minimum reserve-deposit ratio.

Excess reserves

Reserves held by banks above the amount mandated by reserve requirements

money has 3 purposes

Store of value Unit of account Medium of exchange

Money supply

The amount of money available, usually as determined by the central bank and the banking system.

Monetary policy

The central bank's choice regarding the supply of money

Interest on reserves

The central bank's policy of paying banks an interest rate for the deposits that they hold as reserves

Money multiplier

The increase in the money supply resulting from a one-dollar increase in the monetary base

a model of money supply: The model has three exogenous variables

The monetary base B is the total number of dollars held by the public as currency C and by the banks as reserves R. It is directly controlled by the Federal Reserve. The reserve-deposit ratio rr is the fraction of deposits that banks hold in reserve. It is determined by the business policies of banks and the laws regulating banks. The currency-deposit ratio cr is the amount of currency C people hold as a fraction of their holdings of demand deposits D. It reflects the preferences of households about the form of money they wish to hold.

Reserves

The money that banks have received from depositors but have not used to make loans

Financial intermediation

The process by which resources are allocated from those individuals who wish to save some of their income for future consumption to those individuals and firms who wish to borrow to buy investment goods for future production.

Open-market operations

The purchase or sale of government bonds by the central bank for the purpose of increasing or decreasing the money supply

Currency-deposit ratio

The ratio of the amount of currency that people choose to hold to the amount of demand deposits they hold at banks.

Reserve-deposit ratio

The ratio of the amount of reserves banks choose to hold to the amount of demand deposits they have

Bank capita

The resources the bank owners have put into the institution

Financial system

The set of institutions through which the resources of those who want to save are allocated to those who want to borrow

Monetary base

The sum of currency and bank reserves; also called high-powered money

High-powered money

The sum of currency and bank reserves; also called the monetary base.

Currency

The sum of outstanding paper money and coins

Leverage

The use of borrowed money to supplement existing funds for purposes of investment