Money and the Banking System

Properties of money Medium of exchange-asset used to buy and sell goods and services, used to determine value, replaces barter Unit of account-measurement to post prices and keep track of revenues and costs, means for comparing values Store of value-can move purchase power to another time, keeps value, can be reduced if there is high inflation

Why is money valuable? Commodity money-objects used as money, ex.-gold, shells, cattle, cigarettes Fiat money-money with no intrinsic value, but is legal tender since government decrees it as acceptable for payment of debts

Money supply M1-currency (coins and bills), checkable deposits (demand deposits and interest-earning checkable deposits), traveler’s checks M2-components of M1 plus savings deposits (time deposits and money market mutual funds)

Federal Reserve System Central bank that regulates the banking system and controls the money supply The U.S. is divided into 12 districts

Fractional Reserve Banking System that permits banks to hold reserves of less than 100% against their deposits Enables banks to “increase money supply” Required reserves-minimum amount of reserves that a bank is required to keep on hand to back up its deposits Ex.-if reserve requirement 20%, bank must keep $20,000 of $100,000 deposit in its vault

Creating money by extending loans Required reserve ratio-% of deposits that bank must hold Excess reserves-reserves above the amount that bank is required to maintain, these can be used to extend loans Deposit expansion multiplier-amount by which excess reserves will increase money supply, 1/r Ex.- if reserve requirement is 20%, multiplier is 1/ 1/5 or 5 Actual effect of deposit multiplier is less because not all excess reserves are loaned out and people don’t spend all the money they borrow

How the Fed controls money supply Reserve requirements-Fed sets it, composed of currency held by bank and deposits of bank held by Fed Increase in reserve requirements reduces money supply Lower reserve requirements increase capacity to lend, thereby increasing money supply

How the Fed controls money supply Open market operations-buying and selling of U.S. government securities (national debt) with dealers If Fed buys securities, it injects money into economy in form of additional currency If Fed sells securities, it reduces money stock in economy Open market operations influence the size of the monetary base (sum of currency in circulation plus bank reserves)

How the Fed controls money supply Setting the discount rate (interest rate) Discount rate-interest rate Fed charges banking institutions for borrowing funds (short term) Increasing discount rate is restrictive, more expensive to borrow from Fed, banks will increase their reserves Decreasing discount rate is expansionary, banks tend to borrow more and decrease excess reserves Fed funds market-banks with excess reserves lend short-term to other banks to cover reserves

The Treasury and the Fed The Treasury is the budgetary agency. It issues U.S. securities to finance deficits. Concerned with finances of U.S. government. It pays the bills with funds. The Fed is concerned with the availability of money and credit for the economy. Determines money supply.