Money and the Monetary System Outline The definition and functions of money Measuring the money supply Financial institutions The Federal Reserve system (the “FED”) The FED’s policy tools.

What is money? Money is anything that serves as a means of payment or method of settling debts.

Functions of Money? Money is a medium of exchange Money is a unit of account Money is a store of value or wealth

This Note Is Legal Tender For All Debts, Public and Private Fiat Money: Anything which serves as a means of payment by government declaration You are willing to accept money not because it is “backed” by precious metals; but rather because you know it is generally acceptable in exchange

Liquidity refers to two properties of assets or stores of value, namely: The ready convertibility of the asset to generalized purchasing power (or money) The comparative safety of the asset. Money is the most liquid asset available under normal circumstances

Least liquid Most liquid Currency, checkable deposits Savings and time deposits Treasury bills, commercial paper Government and corporate bonds, equities Specialized equipment Ceramics, art, rugs, rare coins Farmland, commercial real estate Home equity

Deposits are Money—But Checks are Not DateItemDebitCreditBalance 1-Jul-03Opening Balance$ Jul-03The Flower Shop$50.00$ (a) Rick’s Account at Delta Bank

DateItemDebitCreditBalance 1-Jul-03Opening Balance$3, Jul-03Rick’s check $50.00$3, (b) The Flower Shop’s Account at Delta Bank

Most Liquid Non- money assets money To measure the money supply, we sum up assets to the far right of the liquidity spectrum

M1 includes:  Currency in circulation  Demand deposits at commercial banks  Travelers’ checks  Other checkable deposits including NOW accounts, ATS accounts, and checkable deposits at credit unions and mutual savings banks

Components of M1, July 17, 2000 (in billions) Source: Federal Reserve Bulletin OCDs means “other checkable deposits.”

M2 includes M1 plus  Savings deposits  Small time deposits (less than $100,000)  Retail money market mutual fund balances

Components of M2, July 17, 2000 (in billions) Source: Federal Reserve Bulletin

The Monetary System The monetary system consists of the Federal Reserve and the banks and other institutions that accept deposits and provide the services that enable people and businesses to make and receive payments.

Financial Institutions 3 types of institutions accept deposits that are a part of the nation’s money supply: 1.Commercial banks 2.Thrift institutions 3.Money market funds: A financial institution that obtains funds by selling shares and uses these funds to purchase assets such as U.S. Treasury bills.

Institution TypeNumber National Unit Banks821 National Banks1,905 National Bank Branches30,809 State Unit Banks2,457 State Banks4,325 State Bank Branches26,450 U.S. Commercial Banks, 1997 Source: FDIC

Legislation: Federal Reserve Act of 1913 DIDMCA of 1982 Depository institutions are required by law to hold a minimum fraction of their liabilities on account at the FED

The Fractional Reserve System Reserves: The currency in a bank’s vaults plus the balance on its reserve account at the Federal Reserve Bank. Required reserve ratio: The minimum percentage of deposits that banks and other financial institutions must hold in reserves. Excess reserves: Banks reserves that exceed those needed to meet the required reserve ratio.

Federal Funds Banks that have excess reserves may loan them to banks with reserve deficiencies These loans are made in the interbank loan, or federal funds, market. The interest rate on loans in the interbank market is the federal funds rate.

A Typical Bank Balance Sheet

The Economic Functions of Monetary Institutions Create liquidity (money) Lower costs Pool risks Make payments

The Federal Deposit Insurance Corporation (FDIC) Created in 1933 A government agency that insures deposits in commercial banks (up to $100,000 per account). Banks pay premiums to the FDIC Bank failures were often a “self- fulfilling prophesy.”

Board of Governors 7 members appointed by the President Federal Open Market Committee Board of Governors plus 5 Federal Reserve Presidents 12 Federal Reserve Banks 3,500 member commercial banks Appoint 3 directors Elect 6 directors

Consolidated balance sheet of the Federal Reserve system (August 31, 1999) AssetsLiabilities Gold certificates, coin, special drawing rights 19,593Federal Reserve Notes 511,545 Loans to Commercial Banks 338Bank reserves 18,800 Treasury securities492,773Treasury Deposits 5,559 (in millions) Source: Federal Reserve Bulletin

The instruments of monetary policy Reserve requirements The discount rate Open market operations

Open market operations are the purchase or sale of U.S. government securities on the open market by the Federal Reserve system

The FED Open Market Committee is the unit in charge of open market operations