MACRO Chpt 17: Money & the Federal Reserve

What are the three functions of money? Which function is the defining characteristic?

1. as a medium of exchange 2. as a unit of account 3. as a store of value Defining characteristic: a medium of exchange

Medium of exchange

money - it is what people exchange for goods and services.

What is the current required reserve ratio? What would happen to the money supply if the Fed decreased the ratio?

10% If the Fed lowered the required reserve ratio, the new simple money multiplier would increases, and so does the money supply.

How do banks create money?

Banks create money whenever they extend a loan. A new loan represents new purchasing power, while the deposit that backs the loan is also considered money.

Why can't a bank lend out all of its reserves?

Because of the required reserve ratio which is the portion of deposits that banks are required to keep on reserve.

What is the difference between commodity money and fiat money?

Commodity money is involves the use of an actual good for money. Fiat money is money that has no value except as the medium of exchange; there is no inherent or intrinsic value to the currency.

The Fed's primary responsibilities:

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.

What is money?

Money is primarily the medium of exchange in an economy; it's what people trade for goods and services. Money also functions as a unit of account and a store of value. Money includes more than just physical currency; it also includes bank deposits, because people often make purchases with checks or cards that withdraw from their bank accounts. M1 and M2 are two measures of the money supply. M2 is the more commonly used measure today.

Define quantitative easing. How is it different from standard open market operations?

Quantitative easing is the targeted use of open market operations in which the central banks buys securities specifically targeting certain markets. Open market operations typically involve buying and selling short-term Treasury securities - that is, bonds that mature in less than one year. Quantitative easing was a new variation of open market operations that was introduced during the slow recovery from the Great Recession. Because the Fed had already bought so many securities on the open market,the lower interest rates caused by these huge purchases had already pushed short-term interest rates down to zero.

How is the discount rate different from the federal funds rate?

The discount rate is the interest rate on the discount loans made from the Fed to private banks. The federal funds rate is the interest rate banks charge each other on interbank loans.

How does the Federal Reserve control the money supply?

The primary tool of monetary policy is open market operations, which the Fed conducts through the buying and selling of bonds. Quantitative easing is a special form of open market operations that was introduced in 2008. To increase the money supply, the Fed buys bonds. To decrease the money supply, the Fed sells bonds. The Fed has several other tools to control the money supply, including reserve requirements and the discount rate, but these tools have no been used in quite a while.

Why is the actual money multiplier usually less than the simple money multiplier?

The simple money multiplier is the rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves. m^m = 1 / rr In the real world our two assumptions don't always hold. There is a more realistic money multiplier that relaxes these two assumptions. 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 the assumption 2), these dollars are not multiplied. The simple money multiplier represents the maximum size of the money multiplier.

Suppose you withdraw $100 from your checking account. What impact would this action alone have on the following? a. the money supply b. your bank's required reserves c. your bank's excess reserves

a. increase b. decrease c. no change

Checkable deposits

are deposits in banks accounts from which depositors may make withdrawals by writing checks. These deposits represent purchasing power that is very similar to currency, because personal checks are accepted at many places.

Federal funds

are 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.

Assets

are the items the firm owns. Assets indicate how the banking firm uses the funds it has raised from various sources.

Discount loans

are the loans from from the Fed to the private banks.

Reserves

are the portion of bank deposits that are set aside and not loaned out. Reserves include both currency in the bank's vault and funds that the bank holds in deposit at its own bank, the Federal Reserve.

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. In open market purchases, the Fed buys bonds from financial institutions. This action injects new money directly into financial markets. In open market sales, the Fed sells bonds back to financial institutions. This action takes money out of financial markets.

Store of value

is a means for holding wealth. Money has long served as an important store of value.

Balance Sheet

is an accounting statement that summarizes a firm's key financial information.

Commodity-backed money

is money that can be exchanged for a commodity at a fixed rate.

Fiat money

is money that has no value except as the medium of exchange; there is no inherent or intrinsic value to the currency.

Owner's equity

is the difference between the firm's assets and its liabilities. When a firm has more assets than liabilities, it has positive owner's equity.

Federal funds rate

is the interest rate banks charge each other on interbank loans.

Discount rate

is the interest rate on the discount loans made from the Fed to private banks.

Moral hazard

is the lack of incentive to guard against risk where one is protected from its consequences.

Unit of account

is the measure in which prices are quoted. Money enables you and someone you don't know to speak a common language.

M1

is the money supply measure that is composed of currency and checkable deposits, also includes traveler's checks.

Currency

is the paper bills and coins that are used to buy goods and services.

Required reserve ratio (rr)

is the portion of deposits that banks are required to keep on reserve. For a given bank, the dollar amount of reserves that it is required to hold is determined by multiplying the required reserve ratio by the bank's total amount of deposits: required reserves = rr x deposits

Simple money multiplier

is the rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves. m^m = 1 / rr

Quantitive easing

is the targeted use of open market operations in which the central banks buys securities specifically targeting certain markets.

Double coincidence of wants

is when each party in an exchange transaction happens to have what the other party wants.

Fractional reserve banking

occurs when banks hold only a fraction of deposits on reserve. The alternative is 100% reserve banking. Banks in a 100% reserve system don't loan out deposits; these banks are essentially just safes, keeping deposits on hand until depositors decide to make a withdrawal.

Bank run

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

Barter

occurs when there is no commonly accepted medium of exchange. It involves individuals trading some good or service they already have for something else that they want.

Required reserves and the simple money multiplier:

Increase in rr --> decrease in m^m Decrease in rr --> increase in m^m m^m = 1 / rr

What are the components of M1 and M2? List them.

M1 is the money supply measure that is composed of currency and checkable deposits, also includes traveler's checks. M2 includes everything in M1 plus savings deposits. Also includes two other types of deposits: money market mutual funds and small-denomination time deposits.

Liabilities

are the financial obligations the firm owes to others.

Money supply (M) =

currency + deposits

M2

includes everything in M1 plus savings deposits. Also includes two other types of deposits: money market mutual funds and small-denomination time deposits.

How does the Fed increase and decrease the money supply through open market operations?

When the Fed wants to increase money supply, it buy securities; when it wants to decrease money supply, it sells securities.

Excess reverves

are any reserves above the required level. excess reserves = total reserves - required reserves

Commodity money

involves the use of an actual good for money. In this situation, the good itself has value apart from its function as money. Ex) gold, silver, Virginia tobacco