Chapter 14: Money, Banks and the Federal Reserve System
Fractional Reserve Banking System
A banking system in which banks keep less than 100 percent of deposits as reserves
Simple Deposit Multiplier
The ratio of the amount of deposits created by banks to the amount of new reserves
Using T-Account to Show How a Bank Can Create Money
The total value of all entries on the right side of the balance sheet must always be equal to the total value of all the entries on the left side of the balance sheet, any transaction that increases (or decreases) one side of the balance shed must also increase (or decrease) the other side of the balance sheet
Reserve Requirements
When the Fed reduces the required reserve ratio it converts required reserves into excess reserves
M1 vs. M2
When we want to talk about money supply they suggest to use M1 Banks play an important role in the money supply, since they control what happens to money when it is in a checking account
M2
A broader definition of the money supply: it includes M1 plus savings account balances, small denomination time deposits, balances in money market deposit accounts in banks, and non institutional money market fund shares Key points about money supply: 1. The money supply consist of both currency and checking account deposits 2. Balances in checking account deposits are included n the money supply, banks play an important role in the way the money supply increases and decreases
Commodity Money
A good used as money that also has value independent of its use as money
Bank Panic
A situation in which many banks experience runs at the same time
Bank Run
A situation in which many depositors simultaneously decide to withdraw money from a bank
Quantity Theory of Money
A theory about the connection between money and prices that assumes that the velocity of money is constant
Asset
Anything of value owned by a person or a firm
Liabilities
Anything owed by a person or a firm
The Functions of Money
Anything used as money should fulfill the following four functions: 1. Medium of exchange 2. Unit of account 3. Store of value 4. Standard of deferred payment
Money
Assets that people are generally willing to accept in exchange for goods and services for payment of debts
Investment Banks
Banks that do not typically accept deposits from or make loans to households They provide investment advice and engage also engage in creating and trading securities such as mortgage-backed securities
Reserves
Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve
What Can Serve as Money?
Five criteria make a good suitable for use as a medium of exchange: 1. The goods must be ACCEPTABLE to (that is, usable by) most people 2.It should be of STANDARDIZED QUALITY so that any two units are identical 3. It should be DURABLE so that value is not lost by spoilage 4. It should be VALUABLE relative to its weight so that amounts large enough to be useful in trade can easily be transported 5. The medium of exchange should be DIVISIBLE because different goods and valued differently
Hedge Funds
Funds that raise money from wealthy investors, and make "sophisticated" investments
Money Market Mutual Funds
Funds that sell shares to investors and use the money to buy short term Treasury bills and commercial paper
Barter
If you wanted to trade, goods and services are traded directly for other goods and services They have a major shortcoming
Unit of Account
In a barter system, each good has many prices Once a single good is used as money, each good has a single price rather than many prices Money allows a way go measuring value in a standard manner
Discount Loans
Loans the Federal Reserve makes to banks
Connecting Money and Prices: The Quantity Equation
M x V = P x Y
Who Carries Out the Monetary Policy
Monetary policy is carried out by the 14-member Federal Open Market Committee
Store of Value
Money allow value to be stored easily: if you do not use all your dollars to buy goods and services today, you can hold the rest to use in the future Other assets can do this too, but money does it particularly well because it is liquid, easily exchanged for goods
Standard of Deferred Payment
Money is useful because it can serve as a starred of deferred payment in borrowing and lending Money facilitates exchanges across time when we anticipate that its value in the future will be predictable Loans, investments
Medium of Exchange
Money services as a medium of exchange when sellers are willing to accept it in exchange for goods or services Money is acceptable to a wide variety of parties as a form of payments for goods and services Most people would accept it
Fiat Money
Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money
Conclusions About Banks and the Money Supply
Real world deposit multiplier is greater than 1 Conclude that: 1. When banks gain reserves, they make new loans, and the money supply expands 2. When banks lose reserves, they reduce their loans and the money supply contracts 3. This is enough to establish the important relationship between banks and the money supply
Required Reserves
Reserves that a bank is legally required to hold, based on its checking account deposits
Excess Reserves
Reserves that banks hold over and able the legal requirement
T-Accounts
T-Account is so much easier to use than a balance sheet A T-Account is stripped down version of a bank balance sheet, showing only how a transaction changes a bank's balance sheet
The Shadow Banking System
The 1990s and 2000s brought increasing important of non-bank financial firms including: Investment Banks Money Market Mutual Funds Hedge Funds
M1
The Narrowest definition of the money supply: the sum of currency in circulation, checking account deposits in banks, and holdings of traveler's checks 1. Currency, which is all the paper money and coins that are in circulations, where "in circulation" means not held by banks or the government 2. The value of all checking account deposits at banks 3. The value of traveler checks
Who Holds the Real Power in the Federal Reserve System
The United States is divided into 12 Federal Reserve districts, each of which has a Federal Reserve bank. The real power within the Federal Reserve System, however, lies in Washington DC, the Board of Governors, which consists of 7 members appointed by the president.
Monetary Policy
The actions the Federal Reserves takes to manage the money supply and interest rates to pursuer macroeconomic police objectives
Velocity of Money
The average number of times each dollar in the money supply is used to purchase goods and services included in GDP
Open Market Operations
The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply To decrease the money supply, the Fed sells its securities These open market operations can occur very quickly
Federal Reserve
The central bank of the United States
Interest Rate
The cost of borrowing funds, usually expressed as a percentage of the amount borrowed
Discount Policy
The discount rate is the interest rate paid on money banks borrow from the Fed By lowering the discount rate, the Fed encourages banks to borrow more money, increasing the money supply Raising the discount rate has the opposite effect
Discount Rate
The interest rate the Federal Reserve charges on discount loans
Required reserve Ratio
The minimum fraction of deposits banks are required by law to keep as reserves
Inflation Rate = Growth Rate of the Money Supply - Growth Rate of Real Output
This equation leads to the following predictions: 1. If the money supply grows at a faster rate than real GDP, there will be inflation 2. If the money supply grows at a slower rate than real GDP, there will be deflation 3. If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation
How the Federal Reserves Manages the Money Supply
To manage the money supply, the Fed uses three monetary policy tools 1. Open Market Operations 2. Discount Policy 3. Reserve Requirements